401(k) vs. IRA: Which Retirement Plan Should You Choose?

Most of us dream of living a worry-free retired life, but few of us take the necessary steps of planning ahead to actually achieve this dream. Proper planning is crucial because you need to identify the right retirement plan which helps you save more and returns more to you than you invest.

This brings us to a perennial question when it comes to saving for retirement, 401(k) vs. IRA, which is better? Let’s understand both these retirement plans and compare them to identify the better option.

401(k)

Among the several employer-sponsored retirement plans, 401(k) is extremely popular. The traditional 401(k). as a preferred retirement savings option, has a number of important characteristics to be aware of:

• The contribution limit for 401(k) in 2019 is $19,000 if you are under 50 and an additional $6,000 as catch-up contributions if you are 50 and above. You can choose how to invest your funds from among those included in the program, but you can only access them without penalty after reaching retirement age at 59½ years of age.

• If you switch employers, you can transfer your funds to the 401k of your new employer.

• Both you and your employer can contribute pre-taxed money. You do not have to pay taxes on the contributions during the year you earned that money but will have to pay taxes when you withdraw during retirement.

• The traditional 401k is particularly beneficial if your employer matches your contribution. It is equivalent to receiving “free money” or a bonus from your employer every time you contribute your own. Such additions can boost your retirement fund quickly.

• However, the funds in this account will be taxed as regular income when you withdraw them for most personal uses, even after age 59½.

Individual Retirement Account (IRA)

There are two variants of Individual Retirement Accounts: The Traditional IRA and the Roth IRA. Your annual contribution towards both these accounts combined in 2019 cannot exceed $6,000 if you are younger than 50 years old. If you are above 50, you can contribute an additional $1,000 as catch-up contributions.

Traditional Individual Retirement Account

• Since there is no income limit, you can save for your retirement irrelevant of how much you earn.

• Your contributions may qualify for a tax deduction, and the income earned in this account accumulates on a tax-deferred basis.

• You can start withdrawing at age 59½, but your withdrawals will be taxed as regular income.

• You are forced to withdraw annually as a traditional IRA comes with a Required Minimum Distribution once you turn 70½.

Roth Individual Retirement Account

• This option comes with certain income limitations. Consequently, not everyone qualifies for it. However, most young adults are not affected by this restriction. Young people consequently have time to save, even as their tax situation changes over time, minimally or dramatically.

• The money earned and withdrawn from a Roth IRA is entirely tax-free once you turn 59½. You can also enjoy penalty-free withdrawals for certain qualified purchases such as buying a first home or higher education.

• There are no Required Minimum Distributions.

The Verdict

The best retirement plans are actually those that suit your needs and contribution capacity. But here are a few key takeaways that might help you choose a good combination:

• An employer’s 401(k) or other similar sponsored retirement plan is a good option in most cases because the contribution limits are higher and a majority of employers offer to match any contributions you make. Even if you need to pay high fees for this 401(k) plan, the free money you earn can compensate for the fees you paid. However, not all employers offer 401(k)s matching contributions.

• If you are still young and expect to fall within the higher tax bracket at retirement, especially if you do not have access to a 401(k) with matching employer contributions, you might want to consider a Roth IRA. If you are older, a Traditional IRA may be the better option for you.

• The good news is that there is no rule against contributing to both 401(k) and an IRA. You can use them both to contribute smartly. For instance, you have the option of an employer’s 401(k) with matching contributions but you need to pay high fees. In this case, you can contribute enough to get the full match and then put the rest of your savings in an IRA. Once you max out your IRA, you can put the additional savings in your 401(k). Even if you pay high fees for these additional contributions, it is still usually a better choice than saving nothing. Of course, maxing out your contributions in your 401(k) and an IRA will be your best general option if you have available funds.

To sum it up, there is no correct answer when it comes to deciding whether a 401(k) is better than a traditional IRA or a Roth IRA. Each option has advantages and disadvantages. Based on your own financial health, you can use any one or all of the options to your advantage to make the most of your savings and boost your retirement fund.

Related Questions

Why is a 401(k) called a 401(k)? The name of the 401(k) is pretty boring and benign. This retirement savings option is so-called because it was codified in the Internal Revenue Code (Title 26) of U.S. Code (our country’s body of law) under subtitle A (Income Taxes), Chapter 1 (Normal Taxes and Surtaxes), Subchapter D (Deferred Compensation), Part I (Pension, Profit-Sharing, Stock Bonus Plans, etc), Subpart A (General Rule), Section 401 (Qualified pension, profit-sharing, and stock bonus plans), Subsection k (Cash or deferred arrangements).

What does the Roth mean in Roth IRA? When this version of the Individual Retirement Account was first introduced in the US Senate in 1989, the co-sponsors were Senators Bob Packwood of Oregon and Senator William Roth of Delaware. When it was finally passed in 1997 as part of the Taxpayer Relief Act, it was named after its chief legislative sponsor, who was, once again, Senator William Roth of Delaware. Had it passed earlier, it just might be known as the Packwood IRA.