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What is the difference between a 401(k) and IRA retirement plan?
It's important to understand all your options to make the most of your retirement savings. Read on to learn more about Roth and traditional 401(k) and IRA plans.
By: Srikari Kunapuli
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Both IRAs and 401(k)s are saving accounts primarily designed for retirement. However, the primary difference between them both is that a 401(k) plan is a qualified retirement account offered by your employer while an IRA is an individual investing tool to save money for retirement set up through an IRA provider. Each employer can decide whether to put a portion of their pay into the plan while in an IRA, the individual can choose to contribute a portion of their earned income periodically to the IRA. With an IRA, you can access many more investments, while with a 401(k) the maximum annual contributor is significantly larger. They can also choose to fund the IRA with money rolled over from a former employer’s 401(k) plan. 

You can always determine whether to start with an IRA or a 401(k) based on whether your employer offers you a 401(k) with a matching contribution. Some employers will put in the same amount or a partial amount of money that you put into the 401(k); this contribution is known as a match.  

  • Your employer offers a 401(k) with a company match: Put enough money in your account to receive the maximum company math. For example, some employers promosie 100% match up to 3% of your salary. This means that if your salary is $100,000, your employer will put in $3,000, as long as you also contribute a minimum of $3,000. Once you get a match, max out on an IRA for the year, return to the 401(k) and resume period contributions there. This will allow you to maximize returns and minimize costs.
  • Your employer does not offer a company match: Move past the 401(k) and open an IRA. You will have access to several investments and also be able to surpass some administrative charges that come with a 401(k). After contributing up to the IRA limit, fund your 401(k) for the pre-tax benefits it offers. 

Both accounts however, allow you to save money in a tax-advantaged way, although the ways in which this benefit is offered may differ. You are also allowed to contribute to both accounts at the same time. 

Within an IRA account, there are two types; a Roth IRA and a traditional IRA. With a Roth IRA, you contribute after-tax dollars, and your money in the account grows tax free. Furthermore, you can usually make tax-free and penalty-free withdrawals after the age of 59 and a half. On the other hand, with a traditional IRA, you contribute pre-tax dollars, and the money in your account grows tax-deferred. Withdrawals are taxed as current income after the age of 59 and a half. A Roth IRA is recommended for someone who expects to be placed in a higher tax bracket once he/she starts withdrawing. A traditional IRA is best suited for an individual who expects to be in the same or lower tax bracket when he/she starts taking withdrawals. Hence, the key takeaway is that you must think about whether in your case it makes more financial sense to enjoy tax-free withdrawals in the future or take advantage of tax benefits today. You can make this call based on predictions of changes in tax rate trends as well. 

Listed below are some of the key highlights comparing all the types of retirement plans discussed above. Note that these pointers are based on data for 2020. 

 

 

401(k)

Traditional IRA

Roth IRA

Contribution Limit

Under 50 yrs: $19,500

Over 50 yrs: $26,000

Under 50 yrs: $6000

Over 50 yrs: $7,000

Advantages 

Employers match 


Higher annual contribution


Contributions lower taxable income every year 


Eligibility not determined by income


Funds may be less expensive than funds purchased outside of 401(k)

Large investment selection offered 


If deductible, contributions reduce taxable income in the year in which they are made

Large investment selection offered 


Qualified withdrawals in retirement are tax-free


Contributions can be withdrawn at any time


There is no minimum distribution in retirement

Disadvantages

Limited investment selection


Distributions are taxed as income (unless you take a Roth 401(k))


Required minimum distributions at age 72. 





Contribution limits are lower than 401(k)


Deduction phased out at higher incomes if you or your spouse are covered by a workplace retirement account


Distributions are taxed as income 


Required minimum distributions at age 72. 

Contribution limits are lower than 401(k)


No immediate tax benefit for contributing


Ability to contribute is phased out at higher incomes

The good thing is that when it comes to a traditional or Roth 401(k), you need to make a consequential choice. You can have both, and decide on a yearly basis where you want to make your contributions. In fact, some employers even allow splitting contributions between both types of 401(k) accounts. In 2020, you can contribute a total of $19,500 to a 401(k), which can be divided into a traditional and Roth 401(k) to reap the benefits of both at the same time. 

Prioritizing your retirement savings now can determine how comfortable you are post retirement. Choose the right account for yourself to make this process easier. The flexibility in being able to have both accounts at the same time can be a huge advantage for you. 

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