401(k) vs IRA: The Good, The Bad, and The Side-by-Side
401(k) versus the IRA. The ultimate retirement planning debate. Now, if you've done any retirement planning, or just went to a cocktail party in your 30s, I’m sure you’ve heard these terms before. Both are essentially retirement accounts but both are very different in how they work and what you can do with them. There are different limits, requirements, and tax advantages that go into each and are important to understand when deciding how to plan for that sweet, sweet retirement. So, we need to talk about them. The pros and cons, differences and similarities, and how you can make these accounts work best for your goals.
The 401(k)
What is a 401(k)?
Simply put, a 401(k) (called TSP or Thrift Savings Plan for government workers) is an employer sponsored retirement investing account. Named after the line in the Federal Tax Code which discusses them, this is an investment account that allows you to automatically contribute from your paycheck every pay cycle and invest that money into a fund offered by your employer. Depending on your employer, they may offer a Traditional 401(k), Roth 401(k), and sometimes both. A Traditional 401(k) is what is called a tax-deferred account, meaning the money you contribute into a Traditional 401(k) won’t be taxed when it goes in, but it will be taxed as regular income when you withdraw it. A Roth 401(k) is basically the opposite. It is a tax-exempt account, meaning that you pay your regular income tax when you get paid, and that after-tax income will grow tax free in your Roth 401(k). Since you already paid taxes on the money, you won’t owe taxes when you withdraw (even on the earnings). However, if your company offers both, then you have a decision to make. Do you think your taxable income will be higher now or in retirement? Of course, this is a much deeper decision and there is a lot to weigh in that. So, stand by for another “The Good, The Bad, and The Side-by-Side” where we’ll get into it further.
The Good
As you read above, the best thing about a 401(k) are the tax advantages. Depending on which one your company offers, you can either drastically reduce your taxable income now or after you retire. You can grow your metaphorical “Nest Egg” without having to pay Uncle Sam on that growth. Many employers also offer 401(k) Matching which means they’ll match your 401(k) contributions up to a certain amount. Depending on the employer, that’s generally about 3% to 6% of your base salary. So, let’s say your employer match is 5% and your salary is $50,000 per year;
Your Contribution = $50,000 x 5% = $2,500
Your Employer’s Contribution = Your Contribution = $2,500
Total Contribution = $2,500 + $2,500 = $5,000
That's like a free $2,500! And you got it just for saving for your own retirement. However, if your employer does match contributions but you don’t contribute to your 401(k), then that total would be $0. You would be missing out on an extra $2,500 a year.
Finally, there is an annual contribution limit. That may sound like a bad thing, but the limit is significantly higher than for an IRA. The 401(k) Contribution limit is $20,500 as of the year 2022. The limit goes up to $27,000 for those over 50 making “catch-up” contributions. Also, unlike an IRA, there are no maximum income limitations to prevent you from contributing.
The Bad
Since a 401(k) is employer sponsored, if your employer doesn’t offer a 401(k) or you don’t have an employer, this isn’t a path you can take. If you are self employed, there are other options for you, including a self-employment 401(k) called a Solo 401(k), but that is beyond the scope of this post. Another issue with a 401(k) being employee sponsored is there is less flexibility in investing options. You can only invest in funds offered by your employer’s 401(k). So just for example, if you really wanted to invest all your 401(k) into REITs (Real Estate Investment Trust) but your employer doesn’t offer that option, you’re out of luck. That also means if your employer only offers Traditional 401(k), then that’s your only option until you switch employers. If you do switch employers, you can always Rollover your 401(k) by rolling it into your new employer's 401(k) program or an IRA. There are some limits and possible tax implications for rolling over your 401(k) though so review them before making the change. Another common feature with most tax advantaged accounts is there are penalties for withdrawing earnings prior to retirement age of 59 ½ years old. This isn’t necessarily the case when it comes to contributions. Depending on if your account is Traditional or Roth, there are different rules for withdrawing contributions since the funds in the account are taxed at different times.
The Side-by-Side
The Good
Annual Contribution Limit: $20,500
Tax Advantaged Account
Possible Employer Match
No Maximum Income Limit
The Bad
Fees on Early Withdrawal
Less Flexibility
Employer may not offer 401(k)
Only Invest in Employer Offered Funds
The IRA
What is an IRA?
IRA stands for Individual Retirement Account and that is exactly what it is. Like a 401(k), it is a tax advantaged account that allows you to invest a portion of your income for retirement. The IRA also comes in both Traditional and Roth options, but unlike the 401(k) this account is not sponsored by an employer. This is an account you open on your own with a brokerage firm of your choice, such as Vanguard, Charles Schwab, or E*Trade. If you are interested in opening an IRA after reading this post, there are affiliate links at the end of this post that can help you. Click here to open an IRA now for a reward. (→E*Trade← or →WeBull←)
The Good
The obvious good is the same as a 401(k) and that is the tax advantages. Unlike a 401(k), since the account isn’t employer sponsored, you have a lot of flexibility in what tax advantages you take and how. You have the freedom to decide if you want to use a Roth or Traditional account, which brokerage you use, and what kind of assets you want to invest in, although some limitations do exist. In some IRA’s, you can even invest crypto, although experts don’t recommend it. You can also open an IRA even with other retirement accounts. So, if you already have and max out a 401(k), you can still open an IRA and make more contributions. It’s also very easy to set up and anyone can open one. You can even open an account in minutes with one of the links at the end of this post.
The Bad
Much lower than the 401(k) limit, the annual contribution limit is $6,000 as of 2022. You can contribute up to $7,000 if you’re over 50. Of course, since you can have both a 401(k) and an IRA, this may not be a big factor. Another possible issue is your contributions must come from earned income in the US. So, if you get a big inheritance and aren’t working, you can’t store that money in an IRA. Also, if you’re working in a foreign country as a US citizen, since your income is not earned in the US, you're not allowed to contribute to an IRA. Now, there are some workarounds, such as if you are working but your spouse isn’t, you can contribute to an IRA on their behalf. However, this can get complicated, so you should speak with a financial planner or tax professional when trying to determine a plan that’s best for you. Like the 401(k), there are penalties for early withdrawal of earnings before age 59 ½. Also, if you have a Traditional IRA, you must start taking contributions after age 70 ½. This is not the case for a Roth IRA. Last but certainly not least, there are Adjusted Gross Income (AGI) limitations. For example, with a Roth IRA, the Modified Adjusted Gross Income (MAGI) limitation is an income of $144,000 for a single person and $208,000 for a married couple filing jointly in 2022. That means if your annual income (as calculated by MAGI) is over those amounts, you can not contribute to a Roth IRA in that tax year. There are other limitations for Traditional IRAs but they can get complicated.
The Side-by-Side
The Good
Tax Advantaged Account
Lot of Flexibility and Freedom
Can Open with Multiple Retirement Accounts
Easy to Set-Up
Anyone Can Open
The Bad
Annual Contribution Limit: $6,000
Fees on Early Withdrawal
Contribution must come from Earned Income
Adjusted Gross Income (AGI) Limitations
The Final Side-by-Side
In the Final Side-by-Side, we will compare what we discussed (in this case 401(k) vs IRA), side-by-side. If I consider it to be something neutral or both items have the same feature, the text will be Black. If it’s something one offers that is better than the other, the feature will be written in Green. Lastly, if the feature is worse than what the other offers, it will be written in Red. So, let's compare!
The 401(k)
Tax Advantaged Account
Annual Contribution Limit: $20,500
Fees on Early Withdrawal
Little Flexibility
Possible Employer Match
Employer may Not Offer 401(k)
No Adjusted Gross Income (AGI) Limitations
Can maintain with IRA
The IRA
Tax Advantaged Account
Annual Contribution Limit: $6,000
Fees on Early Withdrawal
Lot of Flexibility
No Matching Options
Anyone with Earned Income can Open
Some Adjusted Gross Income (AGI) Limitations
Can open with 401(k)
So, there are a lot of differences between the 401(k) and the IRA. The big take-away I want you to leave with though is that YOU CAN HAVE BOTH! If your employer offers a 401(k), you can also open an IRA and your contributions to one won’t affect the contributions to the other. Generally, experts recommend contributing at least up to your 401(k) employer match, then max out your IRA, and then continue 401(k) contributions if you’re able to max them out. This is because;
Making minimum matching contributions keeps you from missing out on free money
An IRA has more freedom than a 401(k), so you can generally set up for better earnings
If you can max out both, max out both. It’s all about those sweet, sweet tax advantages
As always, everyone’s situation is different so I always recommend speaking with a financial planner and a tax professional to determine what route is best for you. Of course, Financially Literacy is the number one factor in Financial Success, so keep learning!
Links
If you’re interested in opening an IRA with E*Trade, click this link (→E*Trade←) and you will get rewarded with up to $3,500 once you open an account and make a qualifying deposit! Reward amount depends on how much you deposit.
If you’re interested in opening an IRA with WeBull, click this link (→WeBull←) and you can earn up to 5 free stocks when you open and fund your account!
*Disclosure* This is NOT financial advice and I am NOT a Certified Financial Planner. All information is provided for educational purposes only and is not to be construed as advice. Everyone’s financial situation is different and requires individualized planning. Seek out a Certified Financial Planner for assistance with your own financial situation.
*Affiliate Disclosure* This post contains an affiliate link. By clicking on the link and utilizing the service, LiveItAwesome LLC and/or the posts author may receive some form of compensation from the linked Affiliate.
