IRA vs. 401K What’s The Difference and Which is Better?

IRA vs. 401K What’s The Difference and Which is Better? December 19, 2011

So you’re thinking about saving for retirement?  Good idea.  According to the EBRI, almost half of baby boomers ages 56-62 are at risk of outliving their retirement savings.

But you already know that you need to save.  The question is how.  More specifically it’s this:  Should I use an IRA or 401k?

IRA vs. 401k – What’s the Difference?

When you’re talking about an IRA vs. a 401k, you need to realize first of all that both accounts are qualified retirement accounts according to the IRS.  This is important because if you ever want to rollover or transfer a retirement account in the future, it it’s crucial that you move it to a qualified retirement account.  Otherwise, you could be penalized and your money subject to taxes.

Now, onto the differences between an IRA and 401k

The most basic difference between an IRA and a 401k is that a 401k is tied to your employer while an IRA is individually managed.  Other differences can be broken down into four categories: contribution and limits, investments options, income limits, and early withdrawals.

Contribution and Limit Differences

401k – Contributions are pre-tax and will be taxed at time of distribution.  (Some plans also offer the ability to make a Roth contribution, simply meaning your contribution is taxed on the front end so that it (and the interest earned) grows and gets distributed tax-free.

401k contributions are made directly through your employer, generally through each paycheck.  Increasing or decreasing your contributions must be done through your employer.  401k contribution limits are set at $17,000 for 2012; employees over age 50 can contribute an additional $5,500 for the year.

IRA – Contributions are pre-tax and deductible.  Roth IRA contributions, however, are post-tax and eligible for tax-free distributions.  In order to make a contribution to an IRA, you must personally write a check or transfer funds to your IRA custodian.

For 2012, you can contribute $5,000 into an IRA; individuals over 50 can contribute $6,000.  The IRS allows you to save this much each year in an IRA and gives you until April 15 to make a contribution for the previous tax year.  This proves to be even more flexible than a 401k, which only allows you to make contributions through December 31 of each calendar year.

Investments Options

Most 401k plans have preset investment options for you to select.  It’s common to have mutual fund options as well as an employer stock option.  The downside to a 401k is that you are limited to invest with the funds available to you.

An IRA, however, can provide you with a wide variety of investment options.  While it can certainly lead to ‘choice paralysis,’ it’s good to have a variety of investment options.  For a more hands off approach to investing, brokerages like Betterment will provide index funds, giving you excellent diversification.

Income Limits

Most employees using a 401k plan won’t have any income limit restrictions.  There are rules regarding ‘highly compensated employees,’ so if you earn more than $110,000, check with your employer regarding your contribution maximums.

Individuals can max out an IRA regardless of income.  The question to ask your tax preparer is ‘how much is tax deductible.’  This will vary depending on your modified adjusted gross income (MAGI).  If you want to contribute to a Roth IRA, you must fall within certain income limits – $105,000 for single, $120,000 for married filing jointly.

Early Withdrawals

Both the 401k and IRA will have 10% penalties attached to a distribution if taken before age 59 ½.  The most important difference is the ability to even take an early distribution.

An IRA will allow you to take a distribution at any time for anything you want – but it’ll be considered taxable income and you’ll be penalized in the amount of 10% at your tax time.

If you have a 401k, you must separate from your employer before you can even think about taking a withdrawal.  Even if you’re ready to ‘eat’ the 10% penalty, you are restricted if you’re still employed by the employer sponsoring the retirement plan.

Similarities of IRAs and 401ks

While there are quite a few differences between IRAs and 401k accounts, there are similarities that should be noted.  As mentioned before, both accounts are qualified retirement accounts that can be rolled over or transferred to other qualified retirement accounts.  (Note: you cannot rollover a 401k until you have terminated employment, become disabled, or reached age 59 ½.)

Both IRAs and 401k accounts are subject to the RMD – required minimum distribution (Roth IRAs not included).  Once retirement account holders reach age 70 ½, they are required to withdraw a minimum amount from their retirement accounts.  This is based on life expectancy and is calculated on an annual basis.  The RMD calculations are based on the IRS RMD table.

Choosing between an IRA and 401k

If you are working for an employer that offers a 401k, you should almost always say yes to the account.  This is especially true if they offer a 401k match.  Don’t leave any money on the table by not opening a 401k and taking the match.

You can have your cake and eat it too by opening an IRA as well.  If you want to expand your investment options and have a little more flexibility, opening an IRA will give you just that.  Take advantage of any 401k matches first (it’s free money and an awesome return on your investment) and max out an IRA next.

Did this clarify your questions on the difference between IRAs and 401ks?  Do you use one or both for your retirement goals?

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