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401(k) Vs. IRA: What’s The Difference And How Do I Choose The Right Option?

Da'Vonne Duncan7-minute read
December 14, 2021

The best time to start saving for retirement is as soon as possible. But which retirement vehicle should you choose? You have plenty of options, but the two most common are 401(k)s and IRAs. You can invest money into both accounts, but how you invest depends on factors like contribution limitations, whether you're employed and your annual income.

Let’s dive into the key differences and the pros and cons of IRAs and 401(k)s.

What’s The Difference Between An IRA And A 401(k)?

IRAs and 401(k)s are retirement savings plans with tax incentives. Both plans give you the option to make consistent contributions to your future. But there are a few distinctions that put these plans in two different categories.

A 401(k) is only offered by employers to their employees. If you’re employed by a company that offers employer-sponsored retirement plans, you can decide if you want to participate and how much you’re willing to contribute from your paycheck. Your employer may add to your funds if they offer a match program.

IRAs are not offered by employers, so it’s up to you to set up your account and contribute to your plan. Often, people will create an IRA account if their employer doesn't offer a 401(k).

There are two different types of IRAs: traditional and Roth. For Roth IRAs, you don't receive a tax break when you deposit money into your fund. However, yearly contributions to a traditional IRA are tax-deductible.

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What Is A 401(k)?

A 401(k) account is an employer-sponsored retirement savings plan. Employers will either invest a percentage of your income or contribute a specific amount each month, which is taken from your pretaxed income.

The most common investment options that 401(k) plans offer are mutual funds, that range from stable to aggressive. Mutual funds are a form of financial vehicle that consists of a pool of money used for investors to fund various money market instruments, such as bonds and stocks.

Be sure to consider the amount you need to retire and your risk tolerance before choosing which mutual fund to invest in. The value of the mutual fund is determined by the performance of the securities that were bought and you want a successful investment.

401(k) Contribution Limits

For 2022, the annual 401(k) contribution limit for employees is $20,500. This is a $1,000 increase from the previous contribution limit, which was $19,500 in 2021. Despite the adjustments, the catch-up contribution for age 50 or older remains unchanged at $6,500.

Employer Matching Contributions

Employers may add to your 401(k) through an employer match. This means your employer will contribute a certain amount toward your retirement savings, depending on your annual contribution. Not taking advantage of this is equivalent to denying free money.

Typically, employers will match a percentage of a contribution up to a certain maximum limit. Like you, employers are limited as well to $61,000 ($67,500 for catch-up contributions) for 2022 or a maximum of 100% of employee's compensation, based on whichever contribution is lesser.

The terms of matching contributions differentiate since sponsoring employers can set their terms according to the Employee Retirement Income Security Act. For instance, other employers may offer a larger match contribution match, such as 50%, compared to others.

For a matching contribution fund to be legally yours, you must wait for the vesting period, which is defined as the length of time you have to stay at a company for matching contributions to be 100% yours.

Vesting periods can be immediate or take up to 6 years or more, this also depends on the company 401(k) guidelines. But, if you decide to leave the company before the vesting period, you lose the right to claim matching contribution funds.

401(k) Withdrawal Guidelines

Generally, people avoid tapping into their 401(k) early, since there are penalties involved for premature withdrawals. However, unplanned situations can compel someone to withdraw funds earlier than expected.

Know that if you’re in a situation where you need your funds earlier than expected, you’re facing a 10% penalty for withdrawing from your 401(k) account before the age of 59½. Additionally, money that’s withdrawn also gets taxed as income. However, you can also use a 401(k) loan.

After 59½, you’re no longer charged a penalty for withdrawal from your 401(k). Typically, people withdraw from their 401(k) when they’re retired, which is usually around the age of 65. Even if you’re older than 59½ and still working, you’re still unable to withdraw from your 401(k) account.

In 2021, the required minimum distributions (RMDs) begin at age 72. This means the IRS requires you to withdraw a minimum amount..

When Should You Use A 401(k)?

As previously mentioned, you should use your 401(k) when you have retired. Waiting until you reached the required age to withdraw funds will allow you to save for your future when you're not working. Generally, people with a 401(k) account will start with 10% of their salary.

However, as you reach milestones, such as a promotion, people will boost their contribution between 15% and 20% of their gross income. Don't forget some employers will contribute as well through a company match. However, both employer and employee have contribution limits.

Although a 401(k) is the leading retirement plan in the U.S., this type of account comes with both pros and cons for retirement planning.

Pros

  • Potential for employer contribution match
  • Higher contribution limits than an IRA
  • Contributions are tax-deductible

Cons

  • Fewer options for choosing which mutual funds you invest in
  • New employees may have a waiting period before they are eligible
  • Difficult to avoid the 10% withdrawal penalty
  • Required minimum distributions

What Is An Individual Retirement Account (IRA)?

An individual retirement account (IRA) is a tax-advantaged investment portfolio that individuals use to save money for retirement. IRAs are set up by you rather than an employer, making it a great option for entrepreneurs or for people who have employers that don’t provide a work-sponsored retirement plan.

Anyone can create an IRA with the help of banks, brokerages and investment firms. To be eligible for an IRA, you must have some form of taxable compensation. Besides retirement, people use IRAs to save for other large expenses, such as their child’s college tuition.

Traditional Vs. Roth IRAS

IRAs are one of the best vehicles for retirement savings and investments. The two most familiar kinds are a traditional IRA and a Roth IRA. Established in 1974, the traditional IRA was the first of its kind, followed by the Roth IRA, which was established in 1997.

Here’s how they differ:

  • Traditional IRA: Contributions are tax-deductible and come from pretax income. When you withdraw, the amount is added to your yearly taxable income.
  • Roth IRA: Contributions come from taxed income and they’re not tax-deductible, but you pay no taxes when withdrawing since they were paid upfront.

Contribution Limits

It’s important to note, the amount of money you can contribute to traditional IRAs and Roth IRAs is limited. For 2021 and 2022, your contributions can’t be more than $6,000. If you’re 50 or older, your contribution cannot exceed $7,000. Keep in mind, excessive contributions are taxed at 6% per year.

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When Should You Use An IRA?

You’re able to access your IRA whenever you want, but if you’re under 59½ years old it’s going to cost you a penalty. After all, rummaging through your savings would defeat the purpose of having a retirement account. Therefore, the government deters you from retrieving your IRA funds until you’re retired.

If you have a traditional IRA and you withdraw money before you’re 59½, you’re looking at a 10% penalty on the amount you withdraw in addition to the income tax you’ll owe on the withdrawal.

In some cases, using your IRA early might be your only option if you have a medical emergency or are unemployed and have limited options. On the bright side, Roth IRAs can give you more flexibility. There are exceptions to an early withdrawal penalty, such as birth/adoption expenses, college tuition and first-time home purchases.

Now that you know it’s possible to avoid penalties and be charged a hefty percentage, let’s review other advantages and drawbacks of an IRA.

Pros

  • Tax breaks
  • More investment options
  • Non-earning spouses can contribute
  • No required minimum distributions
  • Do not need to open an IRA through an employer

Cons

  • Lower contribution limits than a 401(k)
  • Income limits for Roth IRA contributions
  • Penalty for early withdrawals
  • Traditional IRA distributions taxed as income

Can I Have Both A 401(k) And An IRA?

Even if you have a 401(k), you can still open an IRA to save more for your retirement goals, if you can afford to do so. It's common for people to have both accounts since one is provided by an employer and the other is created on your own. Both plans create opportunities to maximize tax-deferred savings and tax-free income, with flexibly.

Please be advised to consult a tax advisor to help you determine which accounts you’re eligible for and what types of accounts may be best, based on your finances.

The Bottom Line: Should You Choose A 401(k) Or An IRA?

If you’re trying to choose between a 401(k) and IRA, the good news is that you don’t have to! You can strategically invest in both, based on your contribution limits. So, if your employer offers a retirement plan, such as 401(k), and agrees to match a percentage of your contributions, take advantage of this option.

However, not all employers will offer a 401(k), which is why you might want to consider getting a head start on your retirement savings with an IRA. Know that if you have the income, whether it's from an employer or not, you have options.

Interested in saving for your future? Try out this retirement calculator to determine how much money you’ll need to save to meet your retirement goals.

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Da'Vonne Duncan

Da’Vonne Duncan is a Blog Writing Intern, covering lifestyle topics for the Publishing House. She has a passion for words and enjoys writing scripts, blogs, narratives, and poetry. She holds a bachelor’s degree in Mass Communications with a concentration in digital video production, from Delaware State University.