IRA v. 401(k) – What’s the Difference?
Do you earn a paycheck? Do you participate in your company’s 401(k) plan? Do you have an IRA? Are you saving for retirement yet? Think you’re too young to worry about this stuff now? Think again. Then grab a pencil, because we’re about to drop some knowledge.
Let’s start with the basics …
What is a retirement account, anyway?
IRA, 401(k) … Toe-may-toe, toe-mah-toe, right? Not exactly.
An IRA (shorthand for Individual Retirement Account) is an investment tool used by people to save money for retirement. Basically, it’s a savings account with some major tax benefits and anyone can open one, depending on the type chosen – Traditional or Roth.
A 401(k) – sometimes called a Defined Contribution Plan – is also a retirement account, but it’s sponsored by an employer so only those employed by the company can contribute.
A Traditional IRA is available to anyone under the age of 70 ½. Yes, the half matters. The money you contribute to the plan is pre-tax, meaning you don’t pay taxes on it until you withdraw the money from the account – which, by the way, must begin by the time you are 70 ½ years old. This is called required minimum distribution, or RMD, and it’s required by law.
A Roth IRA works the opposite way. The money put into the account is post-tax, meaning you pay income tax on it the year it’s earned/invested, but it grows tax-free as long as you don’t withdraw it until you’re 59 ½. (There’s a potential for a 10% penalty if you withdraw the money sooner.) And while there are no age restrictions for Roth contributors, there are income restrictions. For 2017, to qualify for a Roth IRA, the adjusted gross income for a single filer cannot exceed $133,000, and for married couples filing jointly, the limit is $196,000.
Both Traditional and Roth IRAs have yearly contribution limits of $5,500 ($6,500 if over age 50). It’s important to note that this limit is combined across all IRAs. Say you have a Traditional IRA with one company and a Roth IRA with another, you can only contribute a total of $5,500, not $5,500 to each.
The super important part:
Traditional IRA = pre-tax. So you’re going to have to pay that tax eventually.
Roth IRA = post-tax. So you’re going to have to pay the tax on that now, but not later.
If you’re in a lower tax bracket now, and expect to be in a higher tax bracket when in retirement (and let’s be real, a lot of us are in that aspirational tax bracket boat ⛵), it may make sense to pick the Roth IRA. It is always best to consult with a tax advisor before making a decision.
With a 401(k), your employer handles all the hard work. You decide how much of your paycheck will go directly into your account through automatic payroll deductions, using pre or post-tax dollars, and that’s it. Once you make your initial allocation, you don’t have to think about it on the regular, just check in once a year or so in case you want to make any changes. Easy, peasy, employer-enabled growth.
Note: 401(k)s can also be Traditional or Roth. And the same pre and post-tax distinctions apply, but the majority of 401(k)s are Traditional. However, employees are choosing Roth 401(k)s with increasing frequency, particularly millennials. Forbes recently reported that, “More than 17% of younger workers (in their 20s) elected to make Roth contributions to their 401(k)s compared to fewer than 9% of older workers (in their 50s). This is consistent with the premise that younger workers benefit more from the Roth option, given that they often have lower wages and corresponding lower tax rates…”.
Of course, there are contribution limits: For 2017, the yearly limit is $18,000 (the catch-up contribution for those over the age of 50 is an additional $6,000). But the best part of a 401(k) plan is the matching contribution. Many employers match your contribution up to a certain percent of your salary or contribution amount, essentially giving you free money. That’s better than a holiday bonus.
Same, Same, but Different
All three accounts – Traditional IRA, Roth IRA, and 401(k) – are investment tools for retirement. They each have their own rules and restrictions, and they all have contribution limitations.
The three main differences between a Traditional IRA, Roth IRA, and 401(k) are:
- Who can contribute
- When income taxes are paid on the money invested
- The amount of investment options offered in each plan
Both Traditional and Roth IRAs are open to anyone (as long as they meet the age/income requirements outlined above) and offer almost endless investment options (stocks, bonds, ETFs, mutual funds, etc.). However, they provide opposing tax advantages and have differing withdrawal requirements.
Traditional IRAs offer tax-deferred growth since contributions are made pre-tax (taxes are only collected upon withdrawal), whereas Roth IRAs offer tax-free growth since contributions are made post-tax (taxes are collected before being invested and not taxed again when withdrawn – unless you take it out early, remember those penalties we mentioned before?). Withdrawals from Traditional IRAs must begin by age 70 ½, but Roth IRAs have no deadline. The money in a Roth IRA can even be bequeathed to heirs. Yes, bequeathed. We are talking about big money here, so phrases like bequeathed to heirs are par for the course. ⛳
On the other hand, as an employer-sponsored plan, 401(k) plans are only open to company workers and offer only limited investment options (usually a set number of mutual funds). When pre-tax dollars are used (with the more common Traditional 401(k)), investments grow tax-deferred until withdrawal, but there is no withdrawal requirement – as long as you wait until your 59 ½-th birthday to avoid a 10% early withdrawal penalty.
Sounds like 8-year-olds aren’t the only ones who keep track of half-birthdays … We’re looking at you, Uncle Sam.
But what really sets 401(k) plans apart from other IRAs is the matching contributions offered by most employers. Matching contributions allow you to earn more without investing more from your paycheck. Who says there’s no such thing as free money? And when you leave your job, you take your money with you. Just roll your 401(k) account into an IRA to avoid tax penalties and keep earning that compound interest.
See? Same, same, but different.
But how do I choose?
Your age and income level are the first things to look at when deciding which retirement account is best for you. How old are you now? How close are you to retirement? Are you under the age of 70 ½? Will you need to withdraw the money before you are 59 ½? What is your current income and how will it change in the future? Do you file taxes jointly or as an individual? Are you already earning more than the Roth IRA qualifications? Are you tired of answering questions?
But it pays to persevere through the minor interrogation. Because based on your answers, the Traditional IRA age restrictions and Roth IRA income qualifications may guide your decision.
So…do I need both?
In a word, yes – ideally. Diversification is key to limiting risk, even in retirement planning. Having both a 401(k) plan and an IRA can shield you from unknown, future tax changes not seen by your tarot cards, Ouija board, or the psychic at your local bar. Also, having just one account may not be enough for a comfortable retirement, even with senior citizen discounts, thanks to those pesky contribution limits. The more savings tools you use, the more savings you earn.
Recommended Reading: Diversification: How to Choose Investments When You Can’t Predict the Future
Final Things to Consider
Assuming age is less of a concern (you’re probably under 70 ½, unless you’re rocking the septuagenarian swag), the biggest consideration to make when deciding which retirement investment is right for you is the tax benefit of each.
Pre-tax contributions (Traditional IRAs and Traditional 401(k)s) effectively lower the amount of income you are taxed on in any given year, plus you don’t pay taxes on your investment returns until retirement/withdrawal. Post-tax contributions (Roth IRAs and Roth 401(k)s) don’t save you money upfront, but they save you money on the backend since your investment grows tax-free. Thank you, Uncle Sam! Serious upgrade to finding $20 in a coat pocket.
Bottom line: Start early, diversify, and save as much as possible for as long as possible. The more you contribute, the more your assets can grow over time. Don’t pass up the opportunity to participate in your company’s 401(k) plan and max out your contribution limits – especially if they are eligible for an employer match. Why turn down free money?