Updated October 29, 2019

IRA vs 401k: Which is Better?

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Putting money aside each month can help you reach your retirement goals. But is an IRA or a 401(k) the better choice? Keep reading to learn the difference between these two long-term saving plans.

Is an IRA or 401(k) Better?

IRAs and 401(k)s are both great investment options with some key differences. For starters:

  • IRAs are individual retirement accounts managed by you or your financial advisor.

  • 401(k)s are employer-sponsored retirement savings plan managed by the company you work for.

If your employer matches a percentage of your contributions, then a 401(k) is the better choice. You'll be putting extra money away in that instance. Otherwise, the best plan comes down to how much control you'd like to have.

Take a look at the chart below for more information on both plans.

 IRA401(k)
Eligibility
  • Individuals under age 70 ½
  • Individuals working for participating employers
2019 Contribution Limits
  • Under age 50: $6,000
  • Over age 50: $7,000
  • Under age 50: $19,000
  • Over age 50: $25,000
Tax Treatment
  • Contribute after-tax dollars

  • Pay taxes on capital gains upon withdrawal
  • Contribute pre-tax dollars

  • Pay ordinary income tax rate upon withdrawal
Early Withdrawals
  • 10% penalty for early withdrawal before age 59 ½

  • Pay federal income tax rates on the full withdrawal
  • 10% penalty for early withdrawal before age 59 ½

  • Pay federal income tax rates on the full withdrawal
Investment Options
  • Choose where your funds are invested
  • Limited to investments offered in your employer's plan
Unique characteristics
  • Usually tax deductible
  • Employer matching

What is a Roth IRA/Roth 401(k)?
Unlike a traditional IRA, a Roth allows you to contribute after-tax income into a retirement account. Withdrawals after age 59 1/2, including any capital gains, are tax-free.

This option is great for individuals who may be in a higher income tax bracket when they retire. However, married individuals with income greater than $203,000/year and single individuals with income over $122,000/year cannot contribute. You can read our detailed guide to Roth IRAs here.

Contributions

401(k)
Deposits to a 401(k) are made with pre-tax income that is automatically taken from each paycheck. Contributions are typically a set percentage and are predefined when opening the account.

Annual contribution limits include:

  • Under age 50
    $19,000

  • Over age 50
    $25,000

Many employers will match contributions to a 401(k). Employers typically match up to 2–7% of your paycheck if you choose to contribute the same amount.

IRA Contributions
Contributions to a traditional IRA are made with taxable compensation.

Taxable compensation includes income sources like:

  • Hourly wages and tips
  • Commissions and bonuses
  • Self-employment income
  • Alimony

It does NOT include:

  • Rental income
  • Profit from stocks
  • Pensions or annuities

Deposits can be made at any time. However, the deadline for yearly contributions is April 15th of the following year. Deposits can be any amount of your choosing up to the IRS limits.

Annual contribution limits include:

  • Under age 50
    $6,000

  • Over age 50
    $7,000

If you do not have any other retirement accounts, contributions made to a traditional IRA are tax deductible.

Can you have both IRA and 401k?
You can have an IRA and a 401(k) at the same time. Even if you already have an IRA, it's wise to start a 401(k) if the plan is offered by your employer. This will allow you to save more towards retirement and will give you a more diverse investment portfolio.

Withdrawals

At the age of 70 ½, all 401(k) and IRA plan holders must take required minimum distributions. RMDs are usually calculated and withdrawn automatically by the company that manages your retirement plan.

If you do not take your RMD at age 70 1/2, the IRS will impose a 50% tax penalty on the required withdrawal amount.

The penalty on a $1,000 RMD would be $500 if you do not begin withdrawals on time. Learn more about calculating your RMD here.

Early Withdrawals
Any withdrawals from an IRA or 401(k) prior to age 59 ½ are subject to a 10% penalty. However, in certain circumstances, the IRS makes an exception.

There is no penalty for early withdrawals from a 401(k) or IRA due to:

  • Death of the plan owner
  • Total and permanent disability
  • Plan owner is called to active military duty
  • Paying high medical expenses
  • Rollovers into another retirement plan, such as a Roth IRA/401(k).

The IRS makes additional exceptions for IRA holders if the funds are used for:

  • First home purchase up to $10,000
  • Health insurance premiums if unemployed
  • Higher education expenses

Once you put your money into a plan, it's not necessarily stuck only there until you retire. This article from IRAR Trust Company lays out the differences between retirement plan transfers and rollovers and explains what they do.

Understanding Taxes

Withdrawals from IRA and 401(k) accounts are taxed differently.

  • IRA
    Withdrawals are taxed on any capital gains exceeding contributions.

  • 401(k)
    Withdrawals are taxed at your ordinary income tax rate.

Read on to learn more.

Can you lose money in an IRA?
An IRA is an investment account and, as with any investment, you do run the risk of losing money. With an IRA, you can invest in a variety of assets, including stocks, bonds, mutual funds, and ETFs. If the value of those assets decreases, so will your balance. An excellent way to protect your retirement savings is through diversifying your account. You can get more helpful retirement advice here.

Taxation on IRA Withdrawals
Contributions are made with post-tax dollars. Since you have already paid income taxes on this money, you will only be taxed on any capital gains, which are taxed at a much lower rate than ordinary income tax.

For example, an original investment of $1,000 may grow to $1,500 over time. You will be required to pay capital gains tax on $500.00.

Taxation on 401(k) Withdrawals
Contributions are made with pre-tax dollars, so income tax has not yet been paid. Upon withdrawal, you will be taxed on the full amount as if it were regular income.

For example, an original investment of $1,000 may grow to $1,500. When making a withdrawal, you will be required to pay income tax on the entire $1,500.

The income tax rate will depend on your tax bracket at the time of withdrawal. If you expect your income tax rate to increase, consider a Roth 401(k). Since they are funded with after-tax dollars, you will only be taxed on the earnings. Withdrawals are completely tax free after age 59 ½.

What are the Advantages of Rolling Over a 401(k) to an IRA?

  • More Freedom
    Since 401(k) accounts are managed by your company, you have limited say—and fewer options—on where to invest your money. An IRA account through an established broker will offer more investment opportunities.

  • Fewer Expenses
    401(k) accounts may have more (and higher) fees, including a yearly percentage charged by the plan administrator. And since IRAs offer more choices, you may be able to find less expensive ways to invest including free ETFs.

  • Clearer Guidelines
    Unlike 401k(s), IRAs are subject to a uniform set of rules set by the IRS.

What is a SIMPLE IRA?
A SIMPLE IRA is an employer-sponsored retirement plan for small businesses (100 or fewer employees). It works like a 401(k) but there are some differences. For example, employers using a SIMPLE IRA must contribute some percentage for every worker—this is not required with 401(k)s.

How to Open an Account

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Starting a retirement plan should be done as early as possible. The longer your money is invested, the more it can grow.

Opening a 401(k)

A 401(k) can be opened by most employees with a participating employer. Check with your company's HR department to see if opening a plan is an option for you.

Most companies have a minimum of approximately 1,000 hours worked before you can start making contributions.

Follows these steps to open a 401(k):

  1. Apply with HR
    Since you are an employee, HR will likely already have the information necessary to start your plan. This information may include:
    • Name
    • Address
    • Date of birth
    • Social Security number
    • Phone number
    • Photo ID

  2. Choose your investment options
    Decide how much of your money will be invested from each paycheck and select the investment funds.

    Investment account selections are limited to the funds included in your company's plan. The HR department will provide you with a list of available options.

  3. Pick a beneficiary
    Your beneficiary will receive the balance of the plan in the event of premature death.

    They will be taxed at their ordinary income rate on the total amount. However, there is no early withdrawal penalty if the beneficiary is younger than 59 ½.

What happens to my 401(k) if I leave the company?
You may choose to:
  • Leave the plan as is, without making additional contributions
  • Rollover into an IRA or Roth IRA
  • Withdraw the balance (10% penalty under age 55)

Opening an IRA

Most major financial institutions provide services for setting up an IRA. You can choose to start a plan any time as long as you are under the age of 70 ½. However, starting a plan at a young age will give your money time to grow with interest.

Before you open an account, consider speaking with a financial planner. Many brokerages and banks offer free financial planning services.

Since IRAs are individual accounts, you are responsible for managing the plan. But an advisor may be able to assist you.

Follow these steps to open an account.

  1. Fill out an application
    This can be completed using a financial representative or even online. You'll need to share some personal information to start the account. This may include:
    • Legal name
    • Contact information
    • Date of birth
    • Social security number
    • Bank account number for making contributions

    You may be asked to provide photo identification, and your signature will be required.

  2. Choose your investment options
    With IRAs, you can choose from a wide variety of investment accounts, such as mutual funds, stocks, and bonds.

    If you have a personal financial representative, they can provide you with advice and recommendations on investments that are suitable for you.

  3. Pick your beneficiary
    Your beneficiary will receive the balance of the plan in the event of premature death and will be responsible for paying tax on any capital gains.

Bottom Line

IRAs and 401(k)s are effective savings outlets to prepare for retirement. Consider opening both plans to diversify your investment portfolio and be able to save even more.

No matter which plan you choose, finding an investment advisor or financial planner can help manage your funds and offer valuable advice on finding the best option for your needs.

Disclaimer: Opinions expressed here are author's alone. Please support CreditDonkey on our mission to help you make savvy decisions. Our free online service is made possible through financial relationships with some of the products and services mentioned on this site. We may receive compensation if you shop through links in our content.

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