When it comes to retirement, those who are employed will frequently have the option of using a 401k plan from work or an individual retirement account. When deciding upon which option to use, it’s important to take the differences between these accounts into consideration.
What Is A 401k Plan?
A 401k plan is a work-based retirement plan. It’s one of the more popular ways for people to save for retirement, and many Americans have reached millionaire status through these retirement plans. Those who invest in a 401k have preferred tax treatment. There are traditional and Roth 401k options. The traditional option provides a tax deferral. Any money contributed will grow tax-free and will be exempt from taxation when the contributions take place. Those with a traditional 401k will not pay taxes on their contributions or any growth until they withdraw their money. A Roth 401k flips the tax treatment. The money gets taxed going in, but as long as a retiree hits age 59 1/2, the withdrawals will be free from any taxation. With both a Roth and a traditional IRA, there is a 10% penalty for those who take their money out before reaching 59 1/2.
What Is An IRA
An IRA an individual retirement account. Unlike a 401k, which will usually be controlled by a saver’s employer, the investments in an IRA are controlled by a future retiree herself. There are more options with an IRA. Those who hold an IRA account can use them to invest in real estate, stocks, bonds or precious metals. Those looking to invest in an IRA will want to open up a brokerage account to set up the new retirement account. It’s possible to save in an IRA in conjunction with a 401k, and those who can contribute the maximum to a 401k can contribute additional funds for retirement in an IRA.
Like a 401k, there are traditional and Roth options with an IRA. The tax treatment of a traditional IRA is similar to that of a traditional 401k, and the tax treatment of a Roth IRA is similar to a Roth 401k. Both receive preferable tax treatment, and both allow contributions to grow without any taxation. With a traditional IRA, the money goes in before paying income taxes, and withdrawals are taxed at a retiree’s marginal rate. A Roth IRA allows for tax-free withdrawals because the income tax is paid on the front end. Like a 401k, withdrawals from an IRA that take place before age 59 1/2 incur a 10% early withdrawal penalty.
Differences Between A 401k And An IRA
There are several differences between 401k accounts and IRAs. The biggest is the contribution limits that are available for each. When looking at 401k vs IRA accounts, it’s a good idea to take these limits into consideration. According to the experts at SoFi Invest, “…an employee has to voluntarily decide to save in a 401k.” The contribution limit for 401k accounts is $19,500 for both 2020 and 2021. Those who have reached 50 years old can start to make catch-up contributions that allow an additional $6,500 in contributions a year. Put together those who’ve reached 50 years old can contribute $26,000 to a 401k. IRA accounts have lower contribution limits. Those who are not yet 50 can contribute a maximum of $6,000 per year. Catch-up contributions for older workers are capped at an additional $1,000. Therefore, the maximum a person could contribute to an IRA is $7,000.
Another difference between these accounts are related to matching contributions. Employers can opt to offer matching contributions for their employees who use a 401k. The amount that gets matched varies by employer, but common levels of matching are 50% or 100% of the first 6% of an employee’s salary. That would provide an additional $1,500 or $3,000 for an employee who saved $3,000 of a $50,000 salary. Those who save in an IRA do not have the opportunity to benefit from matching funds.
Two final differences are related to Roth IRAs only. Contributions to Roth IRAs are not subject to early withdrawal penalties. Those who hold these accounts can use them as emergency funds. It’s important to avoid withdrawing any dividends or capital gains early, as those would incur the 10% penalty. Additionally, Roth IRAs do not come with required minimum distributions that are common with other retirement accounts.
When it comes to saving for retirement, IRAs and 401k accounts are great options for future retirees to control their level of taxation. They both allow for tax-deferred growth, and those who take advantage can wind up with a great nest egg for their golden years.