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What's the difference between a 401(k) and an IRA?

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

By Jeremy Raffer

 

There are multiple options to choose from when saving for retirement, and sometimes too many choices leads to confusion about which is the right one for you. When planning for the financial security of your future, you want to make sure you consider all options equally. This post will help you understand the major differences between two of the most common ways to save for retirement--the 401(k) and the IRA.

 

IRA vs 401k

 

Table of Contents:

Understanding Account Type vs Investment

How do 401(k)s Work?

Benefits of Choosing a 401(k)

How do IRAs Work?

Benefits of Choosing an IRA

Similarities

Summary

 

 

Understanding Account Type vs Investment

The most common misunderstanding is that both 401(k)s and IRAs are actual investments themselves that will grow. There seems to be some confusion between the account type, and the investments they hold. A 401(k) and an IRA are both account types, meaning they’re places where you can put money in, but aren’t actually investments. First you need to deposit money into these accounts, and then you get to select the type of investments that the account will use--hopefully growing into a shiny golden nest egg down the road. Essentially, there are two categories of retirement accounts and they differ based on whether they are employer sponsored or individually created. So which is the better plan for your needs--a 401(k) or an IRA?

 

IRA vs 401k


How do 401(k)s Work?

The 401(k) is created by the employer for the benefit of the employee. They allow you, the worker, to contribute up to $18,500 per year(in 2018), and an additional $5,000 if you’re over 50. This money can be invested in a preselected and sometimes limited list of mutual funds. Hopefully your investments appreciate over time, during which you don’t have to pay the taxes--a unique benefit to a retirement account. These types of accounts are referred to as tax-deferred because you pay taxes on the contribution now, and then any taxes you would’ve ordinarily paid along the way are deferred. It’s only when you withdraw the money at retirement age(after 59.5) that you have to actually pay the taxes. The money at this point is distributed to you and taxed at whatever your income tax bracket is at the time. This tax deferral is a huge benefit as taxes tend to be a huge drag on the growth of an account.

 

Benefits of Choosing a 401(k)

Another benefit and one that is unique to 401(k)s is that most companies will match a certain amount of your contribution with some of their own money. Employers do this for a variety of reasons including providing an incentive to invest and a way to attract and retain talented employees.

 Let’s say you make $100,000 and you decide to contribute 10% into your 401(k) (a $10,000 annual contribution). Luckily your company says they’ll match the first 5% of your contribution--which adds another $5000, and brings your yearly contribution up to $15,000 now. This matching contribution adds up big time and the value of it is huge.

These contributions automatically happen as payroll deductions from your employer. Every single time you get paid there’s already a chunk that’s been taken out and put into your account and invested according to how you’ve designated on your 401(k) application. It’s one of those “out of sight out of mind” things that over time adds up. Alternatively, you can set up regular contributions with an IRA, but it is not a payroll deduction and is much less automated.

 

401k

 

There are many other distinct advantages to a 401(k). A largely unknown rule is as long as your employed at a company and participating in their 401(k) plan,  you do not have to take distributions at the age of 70 1/2.  This can be quite helpful for someone who doesn't want to deplete their savings because they still have an income.  Almost everyone else must begin to take money out at the age of 70 1/2.

Also, 401(k)s allow for you to make contributions and get the tax deduction, where with an IRA, you might not be allowed to take the deduction if your income is too high (depending on whether you’re an individual or married and if you're also participating in an emplyer sponsered plan like a 401(k)). Lastly, 401(k)s allow you to put away a lot more money than IRAs. You can save up to $55,500 if you take into account your base contribution of $18,500, your catch-up contribution for being over the age of 50 adds $6,000, and the match your company provides along with any profit sharing. 401(k)s can be very lucrative and convenient when saving for retirement.

 

How do IRAs Work?

An IRA (Individual Retirement Account) is different from a 401(k) because instead of being sponsored by an employer, you set up the account yourself. An IRA can be used in conjunction with a company’s 401(k) plan, or used in lieu of one if none are available to you. There are some major benefits that come with an IRA, but several key differences that are worth taking into consideration.


Individual Retirement Account (IRA)

 

Benefits of Choosing an IRA

For starters the contribution limit on an IRA is significantly lower than for a 401(k), at only $5,500 per year--with an extra $1,000 per year allowed if you’re over the age of 50. The big difference other than the contribution limit is that an IRA allows you to choose from a much wider array of investment options. In a 401(k) you are provided with a list of 20 or so choices to invest it, but with an IRA you have much more flexibility. You’re allowed to choose from thousands of individual stocks, mutual funds, ETF’s, bonds, annuities, and a variety of other investments. If you know what you’re doing this is great as it provides you more options enabling you to finetune your investments to align with your personal goals. However if you don’t have professional advice or you’re uneducated about investing this can be daunting and lead to seriously bad choices.

 

Similarities

The two account types hold many similarities though. If you try to make a withdrawal before you’re 59 1/2 years old there are penalties. Early withdrawals will suffer a 10% penalty on the value of the withdrawal in addition to being taxed at your ordinary income tax rate.   The 401(k) and IRA both require you to take money out at the age of 70 1/2. At this point the government has basically had enough of you not paying taxes and want their cut. They force you to take what’s called a required minimum distribution (RMD) which begins at roughly 3.5% of whatever the value of the account is, and then increases each year as you age.

Both accounts allow for your money to grow, do well, and have no taxes along the way eating at that growth. In both account types, when you do finally withdraw the money in retirement, you will be taxed at whatever your income tax bracket is at that time.

 

Retirement Planning


Summary

401(k)s and IRAs are retirement savings accounts where you can deposit money that can then be invested and grow tax-deferred for use later on. 401(k)s are offered through employers and allow you to deposit much more money, but your investment options are much more limited. An IRA is something you can individually open and contribute to even if your employer doesn’t offer a retirement plan, and offers much more investment options. This can be an issue though if you don’t have the ability to make those investing decisions. Once you feel comfortable with the differences between the IRA and 401(k), its time to learn about the Roth accounts offered through both.

Learn more about our Retirement Planning services.

 

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Jeremy Raffer, MBA
Wealth Manager
 
Phone – 201-773-4641
 

 

Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation.  While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.

 

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation.  Any opinions are those of Jeremy Raffer and not necessarily those of Raymond James.