IRA vs. 401k: Which Is Better?
Updated on Jan 28 2019
IRA and 401k plans are some of the best retirement investments for many reasons, including tax benefits and compound interest over time. Learn about each type of plan to decipher which is better for your financial planning and retirement needs.
In days past, retirement used to be a more simple matter as employers offered built-in retirement plans where workers who retired in good standing automatically received a pension check. Today, most workers are required to contribute to their own retirement plans and are in the driver’s seat to strategize various investment programs, other than just Social Security.
Introduction to IRA and 401K types
It’s important to understand how IRA and 401k plans work to help with your retirement planning needs. Investment time horizon, tax bracket and portfolio management all contribute to strategizing which plan works best for you.
401ks, on the other hand, are employer-sponsored retirement plans and are designed to take over company pension plans. Workers have the freedom to do the following with a 401k plan:
- Decide on contribution rates
- Make investment choices
- Plan strategic 401k plan withdrawals
- Strategize how much of their paycheck will go to a 401k with the IRS contribution limits
Here are some advantages and disadvantages to both types of retirement investments:
Advantages of IRAs
Depending on the type of IRA account, here are the main benefits:
The greatest benefit of Roth IRA is tax-free withdrawal earnings at the onset of retirement. Investors contribute after-tax dollars to their Roth IRA accounts and since the money has already been taxed, you can withdraw anytime without owing tax.
If you withdraw your account’s earnings after reaching 59 ½ with an account that is at least five years old, the earnings are tax-free. This can save you substantially if you start out in the lower tax paying income bracket and end up in the much higher income tax bracket in later years. Roth IRA investors pay taxes early so they don’t have to pay taxes on earnings.
Flexibility in Investing
A Roth IRA also offers more flexibility in investing. Although both accounts can invest in mutual funds, 401k are limited to the funds their employers have chosen. Roth IRAs have wider options such as the ability to designate their investment as a self-directed Roth IRA, which includes investment opportunities like gold and real estate.
Roth IRA also lets you withdraw without penalties for valid exceptions such as home purchase and educational expenses. Because you already paid taxes for it you can withdraw the amount you contributed at any age.
Disadvantages of IRA
Many people make common mistakes in their IRA retirement planning, which can be costly. For example, you are required to withdraw money in traditional IRA and – if you don’t – you will incur a penalty. The money you put in IRA can’t just be sitting there forever. Once you reach 70 ½ you have to start taking distributions from your account. The amount you withdraw each year depends on your IRA balance coupled with your life expectancy at the time. If you fail to take the required minimum distribution you will be assessed a 50 percent penalty matching the amount you failed to withdraw.
Also, with a traditional IRA, the money will initially be tax-free. The downside to this is when the time comes to withdraw money in retirement, your distributions will be taxed at your ordinary income rate.
If you don’t have access to a retirement plan yet, you can deduct your entire IRA contribution from your taxes as long as you aren’t yet 70 1/2. Your contribution, however, will be subject to the annual limit, which is currently $5,500 if you’re under 50 or $6,500 if you’re 50 or older.
Advantages of 401k
401k investment plans are one of the best ways to save for your future.
The main advantage of a 401k is the ‘free’ money that comes from employee and employer contributions. If you start early, and if your employer matches a contribution (usually up to 6 percent), you will get the most benefit from compound interest.
Convenient and Tax-Friendly
It is easy to save in a 401k because the money is automatically deducted from your paycheck. There are also tax benefits since contributions roll out of your paycheck before taxable income is calculated. Having the automatic payroll deduction for your retirement makes it more convenient to manage your retirement plan.
Many companies give free classes and tools to make their employees smart 401k planners. You can make a choice from the variety of investments your company offers and decide on which path or strategy is best to make you the most income in the future.
Disadvantages of 401K
401k is to a large part controlled by your employer. Each employee and the employer decide how much to put a portion of pay into a 401k plan. The contributions for all employees are held in a single plan trust, but each individual’s account balance is monitored separately. For 401k plans, the employees have the option of making matching contributions to the employee’s account.
The amount of investment opportunities in 401k is limited only to the suggestions and choices given by the employer. It doesn’t allow for much flexibility on the employee’s part when it comes to investing.
Planning for a Successful Future
IRAs and 401k plans are the two most used retirement plans that offer tax breaks and benefits, but each has its own rules that must be carefully considered depending on your individual choice and situation. Having a balance of different investments will help you build a more solid nest egg.
For example, in addition to 401k and IRA investment options, it’s good to have a retirement plan with a well-balanced portfolio. Whether it’s stocks, bonds, a side-job in retirement, or personal loans to help finance senior care, an expert financial advisor can help you decide what may make the most sense for your unique financial situation so that you are set up for a successful financial future.
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