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IRA vs 401k — How Do They Compare?

No matter what age you are, you should be thinking about investing for retirement. There are several different retirement plan options that you can work with. There are two types of IRAs as well as 401ks, and these are the typical retirement vehicles that people use. 

Individual retirement plans, also known as “IRAs”, can provide you with a method to invest for retirement individually (as the name indicates). Employers may offer a 401k plan that is often coupled with a company matching percentage. Each one of these retirement plans have their own rules, contribution limits, tax advantages and general pros and cons. Let’s review each type of retirement plan and see which one could be right for you. 

What Is An IRA?

As mentioned before, there are two types of individual retirement plans, a Traditional IRA and a Roth IRA. A traditional IRA is different from a Roth IRA in that the tax benefits are upfront, as in you may be able to deduct your contributions from your tax bill for the year in which contributions are made. 

With a Roth IRA, the tax benefits come on the back end. Your contributions are post-tax, meaning that after federal and state taxes are taken from your paycheck, you are then able to contribute to a Roth IRA (up to a certain limit). 

IRA Contribution Limits

Individual retirement plans have a relatively low maximum contribution limit compared to 401ks. Whether you are using a traditional or a Roth IRA, the contribution limit is the same. You are able to contribute as often as you like within a year, as long as you do not go above the limit. There are different specifications for a traditional IRA compared to a Roth IRA as well.   

Contribution Limits For 2020 

  • The maximum contributions for all of your IRA accounts cannot exceed $6,000 in total
  • If you are 50 years of age or older, you can add $1,000 as a catch-up contribution, for a total of $7,000

Income Limitations

  • Traditional: No cap on maximum income to make contributions 
  • Roth IRA: There are restrictions depending on your modified adjusted gross income (MAGI)

With this in mind, your maximum contribution to IRAs is equal to a combination of both the traditional and Roth IRA. For example, if you meet the MAGI requirements and you are able to contribute to a Roth IRA, you can put $3,000 into your traditional and $3,000 into your Roth IRA (or some variation of this to equal the limit) if you so choose. 

IRA Withdrawal Rules

There are no age restrictions on when you can open a traditional or Roth IRA, as well as no age limit for making contributions. This rule started in 2020, as there were restrictions on contributions to traditional IRAs prior to this year. 

For a traditional IRA, you cannot take withdrawals until you have reached at least 59.5 years old, at least without repercussions. You are able to withdraw at any time, there just happens to be a 10% early withdrawal penalty as well as income tax on any amount that is withdrawn. 

For a Roth IRA, you also cannot take withdrawals until you have reached at least 59.5 years old. However, you can withdraw your contributions without penalty at any point in time in case of an emergency. If you withdraw more than you contributed (i.e. the proceeds from the investments), then you will be taxed on that amount as well as the 10% early withdrawal penalty.     

IRA Pros And Cons

The pros and cons of an IRA depends on the type, either traditional or Roth. Both of them share a lot of similarities, but they do have some unique advantages and downsides to each.

Traditional IRA

  • Pros
    • Offers tax advantages during the year contributions are made
    • Freedom to choose any investments without limitations of an employer plan
  • Cons
    • RMDs – required minimum distributions at age 72
    • Cannot receive withdrawals until age 59.5

Roth IRA

  • Pros
    • All earnings on investments are tax free once you reach the qualifying age of 59.5 years old
    • No RMDs! You can keep money safely in a Roth IRA until you die
    • Early withdrawal on contributions (just not on gains however)
    • Freedom to choose any investments without limitations of an employer plan
  • Cons
    • All contributions are after taxes — so there are no upfront tax deductions
    • You have to fall within a certain MAGI range to contribute

What Is A 401k?

A 401k is a type of retirement plan that is tied directly to your employer and their investment plans. As an employee, you can contribute portions of your pre-tax income to your 401k where it will grow tax deferred until it is time to make withdrawals. 

Most companies offer a matching contribution, which adds incentive for employees to contribute at least that amount. There is a much higher contribution limit when compared to an IRA, which makes this an enticing retirement plan option. 

401k Contribution Limits

You may be asking yourself what the latest contribution limit is for a 401k. It seems to update every year, and that is true for 2020 as well where the limit is $19,500. The prior year, 2019, had a limit of $19,000. 

For those that are over 50 years old, there is also a “catch-up” option if you have started late, or if you wish to make a late push towards retirement. The IRS allows an additional $6,500 contribution to the 2020 total limit of $19,500. In total, someone over 50 years old can contribute $26,000 per year to their 401k.  

401k Withdrawal Rules

Similar to other retirement plans, the IRS penalizes early withdrawals of your 401k. Only once you are 59.5 years old, you have retired, or you become disabled then you can begin to take distributions. If you decide to not take withdrawals at that age, or you don’t meet any of those requirements, you can keep the funds in the account until you are 72 years old. At this point, the IRS will require you to take RMDs when you reach age 72. 

401k Pros And Cons

A 401k is a very useful employer sponsored retirement tool. Not only does it have a higher limit than an IRA, it has a potential company match. What other benefits or disadvantages do 401ks hold? 

  • Pros
    • Offers tax advantages during the year contributions are made
    • Company matching up to a certain percentage — free money essentially
    • Larger maximum contribution limit than other retirement plans
  • Cons
    • Limited investment options since the employer provides a small amount of offerings
    • Severe penalties for early withdrawal 
    • There are RMDs at age 72

Consider Guidance From A Financial Advisor

Which plan do you need? What one is the best for me and my family? The answer may not be that simple. Many of the methods you could employ depend upon your personal financial situation and the benefits that are most important to you. 

In case you make very little money, it may make sense to invest in 401k to get the company match as a priority, then a Roth IRA would be the next priority. If you make a lot of money, heavily investing in your 401k, up to the contribution limit, followed by a traditional IRA would be the best tactic. Perhaps you make too much money, then a Roth IRA wouldn’t even be an option in other words.

If you have any questions about any of the retirement plan options, a financial advisor would be a great resource to show you the benefits and downsides to each plan. Feel free to contact one today and review what plan would be best for you.