IRA vs 401(k): Comparing Retirement Accounts, Pros, Cons

Author: Focus on the User | 8 min read
IRAs or 401(k)s for retirement

Many people start thinking about their retirement plans sooner or later. It is so that they can accumulate wealth and enjoy a comfortable retirement. A way many people choose to do this is through retirement savings accounts and consulting a financial planner.

401K and IRA are two popular types of accounts for retirement savings. Both provide you with tax benefits and have distinct features that make them ideal for savings accounts for retirement.

Some people confuse the two accounts and are unsure what sets them apart due to some similarities. While both offer tax-deferred growth (in the case of Roth accounts), there are differences between contribution limits, income limits, and investment choices.

If you are wondering which option is better and will provide you with more benefits, in this article, we have highlighted the benefits and drawbacks of both and the key differences between them.

What is a 401k?

401k is a type of retirement account that an employer provides. It is also known as an employer-sponsored retirement plan or a workplace retirement plan.

Through a 401k, employers provide their employees with an incentive to plan for their retirement. However, some firms require you to work for a certain amount of time with them to be eligible for this type of account.

Hence, you will gain free money if you opt for an employer match.

In 401k, your money grows tax-free, but tax deductions are inevitable at withdrawal.

Types of 401(k) Accounts

There are two major types of 401k accounts—traditional and Roth.

In a traditional 401k, employee contributions are deducted from the paycheck before income tax is cut. Therefore, your income tax is reduced. However, you will have to pay taxes on withdrawals in retirement. If you withdraw past your retirement age, your tax bracket will be lower too.

A Roth 401k makes contributions with after-tax money. The money added will be done after income tax is deducted. Therefore, you won't be required to pay taxes at withdrawal.

How does it work?

Once you open a 401k account, you have to tell your employer how much money you would like to add a contribution to your account. This amount of money will be deducted from your paycheck. The money you contribute will be a tax-free contribution; however, when you plan on withdrawing that money in your retirement, you will have to pay tax according to the tax rate.

Then through the process of employer match, your employer will offer to add in the complete amount or some percentage of what you have proposed.

For a 401k, in 2022, you can contribute $20,500 each year with an additional catch-up contribution of $6500 for individuals over 50.

If you choose to withdraw money before you have turned 59.5, you will be subject to tax penalties.

If you are not too bummed out due to the lack of options for investment and want to accumulate greater wealth for your retirement through employer contributions, 401k is for you.

Benefits of a 401(k)

There are several benefits that the workplace retirement plan 401k has to offer, and some of them are as follows:

Taxable Income is Reduced

In a 401k account, your contributions are not taxed, which means that the amount you want to contribute is separated first, and then the income tax is paid. This lowers the amount of income taxes you will be required to pay.

Incentives of Getting a Sponsored Retirement Employer Plan

401k provides you with the opportunity to open an account through your employer. Additionally, your employer will contribute to your retirement savings account through a company match, hence accumulating more money. Therefore, you are getting free money from your employer. In this workplace plan for employees, if employee contributions equal 2% and the employer decides to match this contribution by half of the employees' and contributes 1%, the employee will still benefit from the 1% extra.

Higher Contribution Limits

401k has higher contribution limits as compared to other retirement accounts. Moreover, even the additional catch-up contribution is not limited to just $1,000. Rather are up to $6,500. Therefore, with a 401k, you can contribute more to your savings account.

Guidance from Investment Pro

In a 401k plan, you are backed by your company. Hence, you might even have better guidance regarding investing efficiently in your account.

Read more: What Are The Benefits Of A 401(k)?

Drawbacks of 401k

Some Employers Might Not Offer

While this is a great incentive for employers, not all employers offer such a plan for their employees. Additionally, not all employers offer this plan instantly after you join. Rather you have to work for some time to be eligible for this plan. Hence whether this type of plan is available depends on the type of employer.

Tax on Withdrawal

As the contributions made for a 401k are pre-tax, you will be required to pay a withdrawal penalty depending upon the tax bracket. The tax rate can be much higher and cause you to pay any taxes when withdrawing.

Lesser Investment Options

When linked with a 401k, you do not have much choice in selecting how you want to invest as the employer restricts your investment choices. Usually, you can invest through mutual funds.

Find Out How to Invest Gold in Your IRA
Explaining both 401k and IRAs

What is an IRA?

IRA is an individual retirement account that you can open to save money for your retirement. An individual is eligible for an IRA account if they earn money. You will just be required to choose the type of account you want.

IRA accounts offer several tax advantages. Unlike a 401k, an employer-sponsored plan, in an IRA, you can open an account with any investment firm, bank, or online brokerage.

There are many different IRAs, such as SEP IRAs, Roth IRAs, traditional IRAs, and Simple IRAs. These different types of accounts have distinct rules regarding withdrawals and taxes.

A traditional IRA is similar to 401k as you can make pre-tax dollars contributions, while in a Roth IRA, you contribute with taxed money, and no tax deductions are made at withdrawal.

Additionally, SEP and Simple IRAs are for those who are self-employed.

IRAs are mainly to save money long-term and enjoy the growth of money in your retirement. You can only withdraw money from IRAs once you turn 59 and a half; however, if you plan to withdraw the money earlier, tax deductions will take place as you will have to pay 10% of the amount you withdraw. Otherwise, you can make tax-free withdrawals depending on the type of IRA account you have chosen.

There are many investment options for an IRA that you can choose from.

How does it work?

You can open an account with any firm you prefer and select your choice of investment option, and benefit from the tax advantages.

The annual contribution limit for IRA is $6000 in 2022, and if you are over 50, you can make a $1000 catch-up contribution.

Furthermore, there are income limits if you set up a Roth IRA account. These limits vary depending on your marital status. However, there are no income limits in the case of a traditional IRA.

Types of IRAs

There are different IRAs, such as traditional IRA, Roth, Simple and SEP. They are different in terms of the tax benefits they have to offer.

Traditional IRAs have contributions with pre-tax dollars. Therefore, the amount you contribute will not have tax deducted from it. However, you will be subject to taxes once you withdraw the money, so your withdrawn money will be your taxable income. However, if you withdraw after your retirement age, your tax bracket will be lower, offering you tax advantages. You will also be required to make minimum required distributions once you turn 72.

In a Roth IRA, the money contributed to your account is after-tax money. Therefore, the money that accumulates in your account will be subject to tax-free withdrawals. While Roth IRA does not require minimum distributions in retirement, you will be subject to income limits. You will also be subject to tax penalties if you withdraw before your retirement age.

Simple IRAs are for businesses with less than 100 employees who earned more than $5,000 in the preceding year, while SEP IRAs are for self-employed individuals and owners of small businesses.

Benefits of IRA

It can be Opened by Anyone Who Earns

An IRA can be accessed by anyone who earns money. Moreover, if you have a spouse who does not earn, you can also open an account for them through IRA. Hence, it gives an advantage to married couples as well.

Several Investment Options

You get a lot of different investment choices with an IRA. You can invest in stocks, mutual funds, bonds, assets with high returns, exchange-traded funds, etc. Hence, you are not restricted with your investment options. These different options provide great flexibility.

Withdrawal Offered Without any Tax Charge.

With the different types of IRA accounts you get, you might make contributions after tax, so your money will keep growing, and you will only have to pay tax once you withdraw money.

Setup is Convenient

Opening an IRA account is a hassle-free process. You can easily set up an IRA account. Additionally, if you are self-employed, it is a great way to save money.

Drawbacks of IRA

Annual Contributions Limits are Low

Despite contributing to your spouse who does not earn, the annual contributions you can make every year are slightly lower. Hence you will be restricted by how much you can contribute.

Lack of Advice for Investment

In a 401k, you can get investment advice from your employer or company. However, as an IRA does not have a link to your employer, you will have to consult some financial advisor on your own to get an expert opinion on what ways would be the best to invest.

What are the diffferences in 401k and IRA

Differences Between IRA and 401k

While IRA and 401k are great retirement savings options, some key differences exist.

With a 401k, you can get an employer match that offers you free money as employers also contribute to match your contribution. While in an IRA, you will only contribute on your own.

There are better investment options in an IRA, while the same is not the case for a 401k because as the company offers 401k, the options are restricted and limited to mutual funds. With an IRA, you will get many options such as stocks, mutual funds, bonds, ETFs etc. And this provides individuals with a higher degree of investment freedom. Despite the many options provided in an IRA, you need to know what each kind of investment is and how to invest in it most efficiently.

While IRAs do offer greater investment choices, the contribution levels are lower than 401k. In the 401k plan, the overall contribution is also greater due to employer matching contributions.

Additionally, IRAs are easy to set up and access. For an IRA, the only eligibility rule is to have earned income or have a spouse who does, and you can easily set up your IRA account. You can open an IRA within 15 minutes only through any physical or online brokerage. While for a 401k, you need to be working in a company that offers a 401k account, and you can not have a 401k account as a self-employed individual.

Depending on the different types of IRA or 401k account you choose, your contribution will either have tax-free growth or growth with tax.

Read more: Why Consider a Self-Directed IRA to Rollover Your 401(k)

How to Choose a Retirement Account

As a 401k is a company retirement plan, you should opt for an IRA if your company does not offer a 401k. This way, through an IRA, you will be able to contribute towards a wide selection of investments. Moreover, an IRA is a better choice when you do not want to pay extra administrative fees. Our 401(k) to gold IRA rollover guide covers everything you need to know before you roll your 401(k) into gold.

Additionally, you should go for an IRA if your company does offer a 401k but does not offer the employer match. In this situation, you should first open an IRA account and keep contributing to it, and once you reach your contribution limit, you can also get a 401k and invest in it. This way, you can have two different retirement accounts and be able to save up more.

Nevertheless, if the company you work with offers a 401k account with a company match, you should grab the opportunity to get free money. It would be best if you contributed to your 401k generously so that your company matches your contribution and your savings grow largely. If you reach your contribution limit for the 401k, you can start contributing to the IRA to boost your overall retirement savings.

You can even have 401k and IRA accounts together to get the most value for your retirement income.

Considering Both Retirement Accounts in Investing

Efficiently planning for your retirement will help you a lot in the future. 401k and IRA are two ways to save money for retirement efficiently. Both these accounts can be beneficial depending on your circumstances, and one can favor you more than the other. IRA rollovers converted to gold bullion is just one strategy Americans use to diversify their accounts.

You can contribute to both 401k and IRA in your retirement plan to get the utmost value out of the two and enhance your retirement funds!

Retirement Investment Resources

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Disclaimer: Content on this website is not intended to be used as financial advice. It is not to be used as a recommendation to buy, sell, or trade an asset that requires a licensed broker. Consult a financial advisor.

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