Two popular methods of retirement savings are through an employer's 401(k) plan or with individual IRA accounts. Each type of account has its advantages and disadvantages.
Understanding 401(k) vs. IRA can help you learn which will be the best way to meet your retirement planning objectives.
What is a 401(k)?
A 401(k) is a retirement plan account offered by employers to their employees who can make contributions to their account with automatic payroll deductions. Their employers may make matching contributions for a percentage of the employees’ contributions. Investment earnings and a 401(k) accrue tax-deferred until the employee begins to withdraw money at retirement.
Read More: Is a 401(k) Match Part of Gross Pay?
How Does a 401(k) Work?
There are two types of 401(k) plans: traditional and Roth
Employees contribute to their traditional 401(k) by making regular deductions from their payroll. The deductions are pretax and will reduce the employees’ income taxes for the year in which the deductions are made.
There is usually an employer match of the employee's contribution. Some employers will match 50 cents up to $1 for each dollar the employee contributes. It makes sense for the employee to contribute up to the annual contribution limit while their employer is matching the contribution because the employer's match contribution is essentially free money that will earn more income for the employee. Presently, the maximum contribution an individual can make is $19,500 for those under 50 or $26,000 for people over 50 who are making catch-up contributions to meet their retirement goals.
The employer makes an arrangement with a financial firm, such as a bank or stock brokerage, to offer a variety of investment options and administer the 401(k) plan. Employees have the option to select from an offering of several different types of stock and bond mutual funds as investment choices.
The earnings from income and capital gains in a 401(k) accrue tax-free and are not taxed until the employee begins to withdraw funds after retirement when the employee's tax bracket is generally lower. Any withdrawals made prior to age 59 ½ may be subject to early withdrawal penalties. The idea is that the employee's tax rate will be lower in retirement than the tax rate while they are working.
If the plan is a Roth 401(k), employee contributions are made with after tax dollars, but withdrawals in retirement can be tax-free since Roth account holders have already paid income tax on their contributions to the plan.
An employee is allowed to have either a traditional or Roth 401(k) or both.
What Happens to a 401(k) if You Change Jobs?
If you change jobs, these are your options for your 401(k):
Do nothing - If you have at least $5,000 in your account, you can leave your 401(k) with your previous employer. This is an easy choice since you're already familiar with the plan and its investments, and you don't have to do anything. However, as a previous employee, you may have limited access to your money and your choices for making investment decisions may be limited.
Roll your investments into your new 401(k) - Keeping your funds with you makes them easier to manage, and the new plan may have more investment options than your old one. On the other hand, a new plan could have fewer investment options that may not satisfy your investment risk profile.
Roll your money into an IRA - Transferring your money from a 401(k) to an IRA, rollover, will give you more investment options and, most likely, lower fees. With an IRA account, you can invest in index funds or other low-cost mutual funds, unlike a 401(k) where your choices were limited to funds offered by the plan administrator.
Cash out - You have to think seriously before you decide to cash out of your 401(k). The major disadvantage is that you may trigger a huge tax bill, and your retirement funds will take a significant hit. Cashing out is almost never a good option.
What is an IRA?
An individual retirement account (IRA) is an investment account that individuals can use to build savings for retirement. Unlike a 401(k), which is set up and controlled by your employer, an IRA is managed by the individual through their own brokerage account with access to investment advice.
There are several types of IRAs: traditional, Roth, SEP and SIMPLE
You can open an IRA at a bank, an online financial advisor or a broker.
Traditional IRA - Presently, you can contribute up to an IRA contribution limit of $6,000 each year to a traditional IRA. These contributions are tax-deductible and provide a tax benefit by reducing your taxable income by the amount of your contribution. If you're older than 50, you can contribute up to $7,000 each year. Withdrawals can begin after age 59 ½ and are taxed at ordinary income rates.
Roth IRA - Withdrawals from a Roth IRA are tax-free, but contributions are not tax-deductible. Contributions to your Roth IRA do not provide a tax break by reducing your taxable income.
A Roth IRA has contribution limits based on income limits. If you are a single filer and have an income below $140,000, you can contribute up to $6,000 per year, or $7,000 if you're 50 or older. Contributions are not allowed for incomes above $140,000.
If you have held your Roth IRA for at least 5 years, you can begin to take tax-free withdrawals after age 59 ½. A significant tax advantage of a Roth IRA is that gains in your investments are not taxed.
SEP IRA - Small business owners with just a few employees or self-employed people can open a SEP-IRA. Contributions are tax-deductible and investments can grow tax-deferred until making withdrawals at retirement. Withdrawals must begin at age 72 and are taxed at ordinary rates. Contributions to a SEP IRA are limited to a maximum of 25 percent of earned income up to $58,000.
Simple IRA (Savings Incentive Match Plan for Employees) - Businesses with fewer than 100 employees can set up SIMPLE IRAs. These plans are easier to set up than a 401(k) but employees’ contributions are more limited. On the plus side, employer contributions are mandatory, so it makes sense for employees to contribute as much as possible to get the maximum employer contributions.
The choice between putting your retirement funds into a 401(k) or an IRA depends on each person's specific situation. In some cases, it may make sense to put retirement funds in both. You have to evaluate the advantages and disadvantages of each to determine which will work best for you.
- Internal Revenue Service: 401(k) Plan Overview
- Internal Revenue Service: One-Participant 401(k) Plans
- Internal Revenue Service: Individual Retirement Arrangements (IRAs)
- Internal Revenue Service: Roth IRAs
- U.S. Department of the Treasury: myRA - Summary of Key Roth IRA Features
- Quicken: 4 Things to Do with Your 401(k) When You Change Jobs
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.