401k VS IRA – Know the Key Differences between Two Tax-Advantaged Options, and learn how to increase your retirement savings .
401(k) vs. IRA is – What’s the difference? Which is the better choice? How to choose?
If you are considering contributing to your retirement account and want to maximize your returns, then you should know the answers to these questions first. Both 401(k) and IRA are investment accounts designed to help you save money by allowing your investments to grow tax-deferred but you need to dive deeper into their differences to arrive at a profitable decision.
What is an IRA?
An IRA is an Individual Retirement savings account that offers pre-tax or after-tax advantages. Every IRA must have a custodian and the choice of investments available to you will greatly depend upon the custodian you choose.
There are three types of custodians. The first will help you establish a new self-directed IRA but your investment options are limited to what they have to sell. The second will allow you to invest in anything allowed by the IRS BUT you have to run everything through them and of course that incurs continuing fees. The third is a passive custodian, they don’t have products to sell AND let you invest in any alternative investment without going through them.
How an IRA Works? Traditional vs. Roth
A 401(k) is administered by an employer but you can set up an IRA on your own and contribute to it. Depending upon your Modified Adjusted Gross Income, you are allowed to have both a 401 k and an IRA. If your current company does not offer a 401(k) or you are a freelancer, you have the capability of having your own personal 401 k and an IRA. There are two types of IRA accounts – Traditional and Roth. The basic features of both these accounts are described in the table below.
| Who is eligible? | You can make contributions if you or your spouse is filing jointly and your compensation is taxable but, you should not be older than age 70½. | There is no age criterion but your adjusted gross earnings must be lower than the specified limits allowed in 2017 and 2018. |
| Are the contributions deductible? | Yes, if you qualify. | No, your contributions are not deductible. |
| What is the contribution limit? | The maximum amount that you can contribute should be the lesser of:
$5,500 or $6,500 if you are older than 50 or Your taxable income for that year |
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| What is the contribution deadline? | The deadline to file your tax return for 2017 is April 17, 2018. | |
| When can I withdraw? | You can make withdrawals at any time. | |
| Do I need to take the required minimum distributions? | You are required to take them before April 1 following the year you turn 70½ and after that by the December 31st of every year. | Not needed if you own it originally. |
| Are withdrawals taxed? | All withdrawals and distributions are taxed. Also, if you are below age 59½ then you are required to pay 10% penaly for early withdrawals. | No, if the two Roth thresholds are met: the Roth is seasoned for 5 years and the IRA owner reaches the age of 59 1/2 |
What is a 401(k) Retirement Plan? How a 401(k) Works?
It is an employer-sponsored retirement savings plan where eligible employees can contribute towards their retirement savings on either an after tax or pretax basis. The employer offering a 401(k) may choose to make a matching contribution to the plan or add a profit-sharing feature.
The biggest benefit of investing in a 401(k) instead of an IRA is the high contribution limit. Employees can contribute up to $18,500 every year and those who are over age 50 can make an additional catch-up contribution of $6,000. The only limitation of a 401(k) is the restricted investment options.
401k vs IRA – Key Differences between Two Tax-Advantaged Options
While both 401(k) and IRA make great options for retirement savings, it is important to know the key differences between them to determine which best suits your unique situation:
| Eligibility | Anyone who is employed in an organization where the employer or sole proprietor offers a 401(k) plan | Anyone who is below the age of 70 ½ for Traditional IRA’s, not Roth, and has earned income can contribute to an individual retirement account. |
| Subjected Taxes | Contributions are tax deductible unless it is a Roth contribution.
Traditional distributions will be treated as ordinary income. Roth distributions are not taxed if the rules are met |
Contributions are tax deductible unless it is Roth IRA. Traditional distributions well be treated as ordinary income. Roth distributions are not taxed if the rules are met. |
| Flexibility | You cannot contribute to your 401(k) plan after the completion of employment. | Your 401(k) can be rolled over to an IRA and you can continue to invest. |
| Contribution Limits (Basic) | $18,500 | $5,500 |
| Catch-up Contribution Limits
(Age 50 and above) |
$6,000 | $1,000 |
| Profit Share | Up to $26,000 | No profit share |
The Basic Difference between 401(k), Traditional IRA and Roth IRA
| Type | Employer Sponsored | Individual account | Same as traditional IRA except that the initial contributions aren’t tax deductible |
| Eligibility | Employer must offer a 401(k) plan | Anyone under age 70½ can contribute | Must meet the income requirements |
| Taxation | Growth is tax-deferred but withdrawals are taxed. | Tax-deferred growth. Pre-tax contributions are allowed if the account holder does not have access to a 401(k). | The income is taxed before contributing to Roth IRA but all withdrawals are tax-free. |
| Contribution Thresholds | Up to $18,000 and an additional catch-up contribution if you are over age 50. | Up to $5,500 and an additional catch-up contribution of $1,000 for those over 50 years of age | Same as a traditional IRA |
| RMD | Withdrawals must begin at age70½. | Withdrawals must begin at age70½. | Not required. The account can be passed on to the heirs. |
| Investment Options | Options limited to funds available in the plan | A wide variety of investment options including stocks and bonds. | Stocks, bonds, ETFs, real estate, mixed-asset funds, index funds and more. |
Making a Sound Choice
If you employer is matching your contribution in a 401(k) plan, you should make the most of the free employer money. You may want to switch to a Roth IRA if your 401(k) does not offer low-fee funds and charges high administration fees. If you are looking for greater investment flexibility, an IRA will bring you the freedom to diversify your retirement savings. To wrap it up, if your income is high, you may benefit from a 401(k) as it allows you to save significantly on your taxable income. However, it is also nice to have a Roth IRA as there are no required minimum distributions and all your withdrawals are tax-free. So, as far as possible you should strive to invest in both 401(k) and Roth IRA if you meet the eligibility requirements.
One Last Thing on Your Retirement Savings
Retire from work, not retirement savings. If you are eligible for both 401(k) and IRA, save as much as you can while keeping within contribution limits. If you are fortunate to have a 401 k plan, contribute and take advantage of any “match”. Consider maxing out an IRA and then go back to funding the 401 k as much as you can.
