401(k) vs. IRA: An Overview
Saving for retirement is one of the most important financial goals that we need to achieve in our lifetime. The choice of which retirement savings account can help accomplish that goal. Whether it's a 401(k) offered by an employer or an individual retirement account (IRA) that you established on your own, the benefits of these accounts can help ensure that you'll have enough money to live on in your golden years.
When employers want to give their employees a tax-advantaged way to save for retirement, they may offer participation in a defined-contribution plan such as a 401(k). Typically, employees would contribute a percentage of their salary to their 401(k), while the employer might offer matching contributions up to a specific limit. Employers might also offer a SEP (Simplified Employee Pension) IRA or if the company has 100 or fewer employees, a SIMPLE (Savings Incentive Match Plan for Employees) IRA.
Individuals can opt to save on their own and open an individual retirement account (IRA). However, IRAs don't provide matching contributions from an employer. Various types of IRAs have specific income and contribution limits, as well as their own tax advantages.
Both IRAs and 401(k)s grow tax-free, meaning there's no tax on the interest and earnings over the years. However, distributions or withdrawals from these accounts are typically taxed at your then-income tax rate in retirement. However, there are IRA accounts that offer tax-free withdrawals in retirement. Also, most IRAs and 401(k)s do not allow withdrawals before the owner reaches the age of 59½; otherwise, there's a tax penalty levied by the Internal Revenue Service (IRS). Again depending on the specific retirement account and a person's financial situation, there can be exceptions to the early withdrawal penalty.
- 401(k) plans are tax-deferred retirement savings accounts offered by employers who may match an employee's contributions.
- Individuals can also set up a traditional or Roth IRA, which do not have employer matching.
- IRAs generally offer more investment choices than 401(k)s, but permitted contribution levels are much lower.
A 401(k) is a tax-deferred retirement savings account offered by employers to their employees. Employees contribute money to their account via elective salary deferrals, meaning a percentage of their salary is withheld and contributed to the 401(k).
The money is deposited in various investments, typically a line-up of mutual funds, as selected by the sponsor. The fund choices are designed to meet a specific risk tolerance so that employees may only take on as aggressive or conservative a risk with which they are comfortable. Investment income accrues and compounds tax-free.
Many employers are also starting to offer Roth 401(k)s. Unlike a traditional 401(k), contributions are funded with after-tax money, so they are not tax-deductible; however, qualified withdrawals are tax-free.
Contributions to 401(k) accounts are made pretax, meaning the total of the contributions would reduce your taxable income for that year by the contribution amount. For example, if an employee earned a $50,000 salary and contributed $10,000 to a 401(k), the taxable income for the year would be $40,000—all else being equal.
As of 2020 and 2021, participants can contribute up to $19,500 per year to a traditional or Roth 401(k), with an additional $6,500 catch-up contribution allowed for people aged 50 and over.
Employer Matching Contributions
Typically, employers match a percentage of their employees' contributions up to a certain limit or percentage. An employer might match based on how much the employee contributes annually. For example, an employer could match 50% of an employee's contribution up to 6% of their salary. If an employee contributes 6% of their salary, the employer will contribute a 3% match.
If the employee doesn't contribute the full 6%, they might not qualify for a match and receive nothing or receive a reduced portion from the employer. To receive the employer match, the employee typically must contribute a minimum amount or percentage of their salary. It's important to review the 401(k) retirement plan documents to determine if there's an employer match and, if so, what's the maximum match and the minimum employee contribution needed to qualify for a matching contribution.
The IRS has established limits on the total contributions—both employee and employer— to a 401(k). For 2020, the annual contributions to an employee's account can't be more than $57,000 or $63,500, including $6,500 in allowed catch-up contributions for those employees aged 50 and over. For 2021, the total amount of annual contributions to an employee's account can't exceed $58,000 or $64,500, including catch-up contributions.
Distributions from 401(k)s
Withdrawals are taxed at the person's income tax rate, and there's no penalty for withdrawals as long as the distributions are made at age 59½ or older. An employee may be permitted to take loans or hardship withdrawals from a 401(k). Loan repayments are generally deducted from the employee's paycheck.
Many 401(k)s have vesting requirements for matching contributions, but SEP and SIMPLE IRAs are 100% vested as soon as a contribution is made.
Individual Retirement Accounts (IRA)s
There are several types of IRAs, which are tax-deferred retirement savings accounts established by an individual. IRA accounts can be held by banks, brokerages, and investment firms.
An IRA account can be as straightforward as a savings account or certificate of deposit (CD) at a local bank. IRAs held by brokerage and investment firms offer IRA owners more investment options than 401(k)s, including stocks, bonds, CDs, and even real estate. Some assets, such as art, are not permitted within an IRA, according to IRS rules.
Unlike 401(k)s, IRAs do not generally permit loans.
Traditional and Roth IRAs
Like 401(k)s, contributions to traditional IRAs are generally tax-deductible. Earnings and returns grow tax-free, and you pay tax on withdrawals in retirement. Contributions to a Roth IRA are made with after-tax dollars, meaning you don't receive a tax deduction in the year of the contribution. However, qualified distributions from a Roth are tax-free in retirement.
IRA Contribution Limits
Annual contribution limits for traditional and Roth IRAs are $6,000, as of 2020 and 2021, with an additional $1,000 catch-up contribution allowed for people 50 and over.
SEP and SIMPLE IRAs
SEP and SIMPLE IRAs are offered by employers to their employees and are similar to 401(k) accounts in many ways, but there are some differences, chief among them their contribution limits.
Both SEP and SIMPLE IRAs were designed to make it easy for employers to set up a retirement plan for employees. They have fewer administrative burdens than 401(k) plans. For the self-employed, "employer" includes an owner/employee.
SEP IRAs have higher annual contribution limits than standard IRAs, and only your employer can contribute to it. As of 2020, employers can contribute as much as 25% of an employee's gross annual salary as long as the contributions do not exceed $57,000. In 2021, the contribution limit is $58,000 or $64,500 if the employee is age 50 or older.
SIMPLE IRAs contributions work differently than SEP IRAs and 401(k)s. An employer can either match up to 3% of an employee's annual contribution or set up a non-elective 2% contribution of each employee's salary. The latter doesn't require employee contributions.
The contribution limit for employees is $13,500 in 2020 and 2021, and those 50 and older can make an additional catch-up contribution of up to $3,000.
401(k) vs. IRA FAQs
Is It Better to Have a 401(k) or IRA?
Whether a 401(k) plan or an IRA is better for an individual depends on what features are more desirable. A 401(k) allows for more money to be contributed each year on a pretax basis versus an IRA. A 401(k) is also somewhat easier to manage for those who don't want to make investment decisions since the plan would likely offer mutual funds.
However, a 401(k) might have a limited number of investment choices, depending on the financial provider managing the plan. An IRA, on the other hand, can offer more investment choices if it's opened with an investment firm such as a broker. Also, an IRA allows the investor to manage those investments and hold their money in an IRA savings account, which many 401(k)s do not allow.
Is a 401(k) an IRA Account?
No. Despite both accounts being retirement savings vehicles, a 401(k) is a type of employer-sponsored plan with its own set of rules. A traditional IRA is an account that the owner establishes without the employer being involved.
Is a 401(k) an IRA for Tax Purposes?
Not all retirement accounts have the same tax treatment. There are different tax benefits for IRAs and 401(k)s. Roth IRAs don't offer a tax deduction for contributions, but withdrawals are tax-free in retirement. Traditional IRAs offer a tax deduction while 401(k)s allow pretax income to be deposited, which reduces taxable income in the year of the contribution. Distributions in retirement from 401(k)s and IRAs are considered taxable income.
Can You Lose Money in an IRA?
Yes. IRA money that is held by a brokerage or investment firm could be invested in securities such as mutual funds or stocks, which could decline in value. As a result, an IRA owner could potentially have less money in retirement than the total amount of contributions over the years.
Can You Roll a 401(k) Into an IRA Without Penalty?
Yes. The IRS allows for a rollover or transfer of your funds from a 401(k) to an IRA. However, the process and guidelines outlined by the IRS must be followed so that the IRA transfer doesn't count as a distribution, which could incur a penalty.
Michelle Mabry, CFP®, AIF®
Client 1st Advisory Group, Hattiesburg, Miss.
A 401(k) is an employer-sponsored plan to which you can make elective deferrals. In 2020 and 2021, you can contribute up to $19,500 per year, plus a $6,500 catch-up amount for those 50 years of age and over.
Employer plans typically provide some amount of matching contribution. You get to select from a menu of mutual funds or ETFs, as outlined by your individual plan. An IRA is not tied to an employer. If your income is below a certain amount and you are not covered by an employer plan, you can contribute up to $6,000 per year plus a $1,000 catch-up contribution for those age 50 and over.
The benefit of an IRA is that your investment choices are much greater and almost unlimited. The costs of each need to be considered, and they will vary depending on the investment selection.