Differences between 401k vs. IRA
The beginner’s guide on choosing a retirement savings account
|Written by Tom Yeung, CFA | CDFA
Investment Advisor & Fund Manager, Jurnex Financial Advisors
As a financial advisor, I often get folks asking: what’s the difference between a 401k vs. IRA?
It can get confusing since the two plans share many similarities. After all, they’re both tax-advantaged retirement plans that can help you save tens to hundreds of thousands of tax dollars.
But understanding their differences is essential for YOUR retirement. Which one do you choose? Where to open one? And how much should you contribute to each?
In this guide, we’ll take a look at both plans and see – 401k vs. IRA – which one is right for you.
As always, I recommend you reach out to an investment pro before making a final decision about retirement planning – that’s because financial mistakes are far easier to fix today than in the future. But to get you started here is an in-depth guide to compare 401k vs. IRA plans.
What is a 401k plan?
401k plans are employer-sponsored retirement plans. Your employer is responsible for setting up the system, working with the custodian, and directing your savings into the account. There is very little work on your part, besides choosing how much you want to invest, and picking which securities to buy.
It started with a tax loophole…
401(k) plans were an unintentional result of a 1978 Congressional Act. That year, the Revenue Act inserted a provision — Section 401(k) — that allowed employees to avoid taxes on deferred compensation.
Companies quickly began to use that tax loophole to offer tax-free benefits to employees. By 1981, almost half of all major companies were considering using the 401(k) loophole.
…and ended as one of the largest US savings plans
These days, 401(k) plans are far more standardized. They allow companies to offer tax-deferred savings to employees. Your income can be saved tax-free, and you only have to pay taxes when you withdraw the money at retirement. Your savings are also exempt from capital gains taxes, which means tens or hundreds of thousands of dollars in tax savings over your lifetime.
Today, around 75% of Americans have access to an employer-sponsored 401k plan (or 403b plan for public-sector workers). To learn more about 401k’s, see my guide to 401k investing.
What is an IRA?
IRA plans are individual-sponsored retirement plans. You are responsible for opening an account, depositing money and reporting taxes to the IRS.
IRAs (individual retirement arrangements) were created by the ERISA Act (Employee Retirement Security Act) in 1974. Unlike the 401(k), the IRA was an intentional act to allow individuals to save on a tax-deferred basis.
Traditional IRA: Initially, there was only one type of IRA: the traditional IRA. These accounts allowed savers to defer taxes. In other words, you’re taxed sometime in the future instead of today. The assumption is that your future charges will be lower since you’ll be retired.
Roth IRA: In 1997, Congress added a second type of IRA: the Roth IRA. These accounts allow savers to eliminate all future taxes. You pay income taxes today, but then all Roth IRA investments then grow tax-free. Roth IRAs are phased out for high-income earners, approximately $120,000 per year for single filers and $190,000 for joint.
BOTH IRA types also have zero-percent capital gains tax.
Not only will you save on income tax, but you’ll also save on capital gains. All savings, interest, dividends, and capital gains are non-taxable for both Traditional and Roth IRAs.
Almost anyone who receives taxable income and is under age 70.5 can contribute to a traditional IRA. Other IRA types include SIMPLE and SEP IRAs, which are for self-employed and small-business owners respectively.
Key differences between a 401k vs. IRA plans
Even though they share many similarities, a 401k and IRA have several critical differences.
401(k)s = employer | IRA = individual
401(k). Your employer deals with the legwork, including deducting your contributions, recording taxes on your W-2 form, and managing paperwork with the custodian.
IRA. You need to take care of opening an account and investing your own money. It’s easy to forget to contribute. Studies show that only 13% of Americans consistently contribute to an IRA, compared to 45% to a 401k.
Age of withdrawal
401(k)s = 55 years | IRA = 59.5 years
401(k). Usually, the minimum age withdrawal is 59.5 years to avoid the 10% early-withdrawal penalty. However, the IRS rule of 55 allows any worker between age 55 to 59.5 that has been laid off, fired or resigned to pull money out of their 401(k) or 403(b) plan without penalty.
IRA. IRAs typically only allow withdrawals at age 59.5.
What you can buy
401(k)s = employer decides | IRA = you decide
401(k). Because the plans are employer-sponsored, the employer will choose allowed investments.
Typically, employers will have a generous selection of mutual funds and ETF’s. Some also offer the ability to buy individual stocks. But not always.
IRA. IRAs have far more flexibility in what you can buy. If you open an account with an online brokerage, you can typically only invest in exchange-traded products, including bonds, stocks, ETFs, and funds. But that’s a limitation of the brokerage, not the IRA itself. If you choose a self-directed IRA account, you can invest in far more things according to IRS rules. These investments include real estate, gold bullion, and stock options.
401(k)s = high limit | IRA = lower limit
401(k). In 2019, investors can contribute up to $19,000 per year. If you are over age 50, you can contribute up to $25,000 per year in what’s known as catch-up contributions.
IRA. In 2019, investors can contribute up to $6,000 per year. If you are over age 50, you can contribute up to $7,000 per year. You need to meet specific income restrictions to qualify for Roth IRAs.
401(k)s = employer matching | IRA = self-made
401(k). Around half of employers offer 401k matching. That means every dollar contributed to your 401(k) gets matched by your employer up to 3-10% of your salary, depending on your company’s policies.
IRA. While IRAs don’t have an employer match, there are still important reasons to save. Annual contribution limits are relatively low, so it takes consistent habits to build up significant savings.
When should you start investing in a 401k vs. IRA?
For both 401k and IRA investing, I recommend all clients start investing in retirement savings once they meet THREE key milestones.
1. Pay down all high-interest debt. You should repay debts with >8% as quickly as possible. Doing so allows you to save even more money in the future. Low-interest debt such as mortgages and federal student loans can be paid down more slowly over time.
2. Have 3-6 months of emergency cash. Before you invest in long-term retirement funds, I suggest you have at least 3 to 6 months of money to cover medical and other emergencies. While investing is important, access to cash can be even more so in the short term.
3. Become eligible for your company’s 401k (401k only). According to Safe Harbor rules, employers must allow all qualified employees into their 401(k) plan. However, these rules do enable employers to withhold 401k plans for those with less than one year of tenure.
But once you’ve achieved those three milestones, when should you start investing in your 401(k) or IRA?
The answer is simple: as soon as you can!
How to start a 401k vs. IRA?
Once you’ve decided to start a 401(k) versus IRA, the way you open these two accounts are quite different.
401k. Talk to your employer
Because 401(k) plans are employer-sponsored, you need to go directly through YOUR EMPLOYER to open a 401(k) plan. Most HR departments will automatically inform employees about 401(k) plans. And if you’re not sure, check to see whether they have one available.
Your employer will then ask you to decide:
1. Contribution. How much you want to contribute?
2. Investments. Which investments do you want to buy?
IRA. Talk to a brokerage firm
An IRA, on the other hand, needs YOUR attention. To open an IRA account, you first need to choose an IRA custodian. Most people choose a low-cost brokerage, such as Fidelity, Charles Schwab, or Vanguard. (Read my reviews of the top four low-cost brokerages for more information.) You can also open a self-directed IRAs. These accounts allow you to invest other assets, such as real estate, options and gold.
The steps to opening an IRA are:
1. Select brokerage firm. Choose a low-cost firm that fits your needs
2. Open an account. This can be done in-person or online
3. Fund your account. Usually through a bank wire or check deposit
4. Select investments. Create a diversified portfolio that reflects your financial goals
5. Buy investments. Unlike a 401(k), an IRA requires YOU to buy the investments yourself with a market or limit order.
Which is better? 401k vs. IRA
Now that you know the difference between a 401k vs. IRA, your next question might be:
“Well, Tom, which one is right for me?”
The answer is quite simple: both! That’s because each has benefits that complement the other.
401k: best for long-term ETF and stock investing
- Simplicity. If your employer offers 401(k) plans, it’s as simple as signing up for the program, picking up a handful of long-term investments, and letting your employer do the rest. That’s why more than 90% of workers with automatic 401(k) enrollments do so. It’s just that easy.
- Employer matching. 50% of 401(k) plans also have employer matching. Each dollar you save receives an additional dollar from your employer. If your employer offers to match, you should take full advantage. It’s free money. And I’ve never known anyone to turn down free money.
IRA: best for alternative investing and those who don’t have 401k plans
Even if you contribute to a 401(k), it’s still a good idea to invest in an IRA as well.
- Flexibility. You can use your IRA to buy real estate and other non-exchange products by opening your account with a self-directed IRA custodian
- Employer independent. If you change employer, you don’t have to worry about rolling over your IRA. Your IRA will always be in your name no matter where you work.
So if your finances allow it, you should invest in both a 401k and IRA. Each has its unique strengths. And investing in both diversifies your nest egg.
How much should you contribute to a 401k vs. IRA?
The exact portion you save in your 401(k) versus IRA depends significantly on your retirement goals and your current financial situation. I generally recommend people save at least 15% of their income, but this number can change depending on many factors.
Here are some factors that can play a part in that decision.
- Public pensions. Access to public pensions reduces the need for 401k or IRA investing.
- Tenured careers. A stable, long-term job can vastly reduce long-term investment risk. Any losses in your portfolio can be made up by additional years of steady work. (So college professors may find themselves needing to save less for retirement.)
- Inheritance and family support. If you expect to either inherit wealth or want to leave money to family or causes, this can significantly influence how much you save. I generally recommend clients to never count on receiving an inheritance unless you have an irrevocable trust.
- Retirement age. The earlier you want to retire, the more you’ll need to save.
- Lifestyle. People with higher retirement needs should save more for retirement. Alternatively, those wishing to retire to low-cost countries might find themselves being able to save far less still maintain a comfortable lifestyle.
- Lifespan and family medical history. Does your family have an account of good health? A genetic risk to Alzheimer’s and certain cancers could mean saving more to anticipate medical needs.
Are YOU ready to master your 401(k)?
If this seems like a lot of information, don’t worry. The great news is you don’t have to do this alone. There are plenty of qualified retirement experts who understand the importance of correctly investing your 401k and IRA.
At this stage, I generally tell people not to worry about costs. It’s worthwhile to spend 3-4 hours with an investment pro today than make an investment mistake and not realize it for decades to come.
Where to find more resources
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That’s because I’ve helped invest client money for over a decade in the same old-fashioned way. And that’s to seek out great companies in great industries that can you can buy at a discount to their fair value. Sounds too simple to be true? Give me a call today, and I’ll show you that it’s still possible after all these years.
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