The IRA vs 401(k): Which is Right for You?

February 19, 2013

roth ira, ira, 401kEvery day adults are realizing more and more that they need to take control of their own retirement savings. Regardless of political affiliation, most can agree that the sand is running out of the social security system hourglass, and many of us will never see a dime for our efforts. Those of us that will, still need to think about a secondary income stream, as those checks will not be enough.

Every penny you are able to save now may be the difference between struggle and comfort later in life. There are some options at your disposal that allow you to invest in with tax-free growth. The IRA and 401(k) are concepts you may have read about or heard about on CNBC, but which one makes the most sense for you? One? The other? Both? Let’s work through this together.

What is an IRA?

An IRA, or Individual Retirement Arrangement, is an account that has special tax incentives, designed to help individuals save for retirement. As this is an individual account, employers are not involved in the set-up or funding of these accounts. In order to contribute to an IRA, you must have earned income for that year.

The two most common IRAs investors use are the Traditional and Roth IRAs. Here is some quick information on both:

  • Traditional IRA – Depending on your tax filing status and income level (check chart below), your contribution may be tax deductible. All growth in an IRA is tax-free, and the owner pays taxes on any distributions as “income” in the year they make that withdrawal.
If Your Filing Status Is… And Your Modified AGI Is… Then You Can Take…
Single or
Head of Household
$59,000 or less A full deduction up to the amount of your contribution limit.
more than $59,000 but less than $69,000 A partial deduction.
$69,000 or more No deduction.
Married filing jointly or Qualifying   widow(er) $95,000 or less A full deduction up to the amount of your contribution limit.
more than $95,000 but less than $115,000 A partial deduction.
$115,000 or more No deduction.
Married filing separately less than $10,000 A partial deduction.
$10,000 or more No deduction.
If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the “Single” filing status.

 

  • Roth IRA – There are no tax deductions for Roth contributions. The growth is still tax free, and all withdrawals are also tax-free. There are income limits as to who can contribute to a Roth however. The income levels are:
    • Single/Head of Household – Above $127,000
    • Married Filing Joint – Above $188,000
    • Married Filing Separately – Above $10,000

What is a 401(k)?

The 401(k), which refers to the tax code in the Internal Revenue Code where this is created, is another tax-advantaged savings plan set up to help individuals save for retirement. This one, however, can only be used through your employer.

The 401(k) allows individuals to take money from their paycheck “pre-tax” and place it in a special investment account. It lowers your taxable income in the year that you make the contributions and the money grows tax-deferred like an IRA.

How Much Can I Contribute?

IRA

The Traditional and Roth IRA have the same 2013 maximum allowable contribution of $5,500 per year. Anybody at the age of 50 or older can make an additional “catch-up” contribution of $1,000 for a total of $6,500.

401(k)

The amount of money you are allowed to contribute to a 401(k) in 2013 is $17,500. Anybody at the age of 50 or older can make an additional “catch-up” contribution of $5,500 for a total of $23,000 per year.

Is There an Employer Match?

IRA

No. This type of account is setup by an individual person and not connected to their employment. Therefore no employers are involved in this account in any way.

401(k)

YES!  This is the big advantage of 401(k)s. Most employers will offer some type of matching contribution. If there is a match in your 401(k), it is in your best interest to participate enough to take complete advantage of the full amount offered by your employer. To not do so would be like leaving money on the table!

What Can I Invest In?

IRA

You can usually invest in many different investment products in an IRA, ranging from safe to risky. Some examples are:

  • CDs
  • Bonds
  • Equities
  • Mutual funds
  • ETFs
  • Annuities

401(k)

Each employer set-up 401(k) plan offers a variety of investment options, but it is limited compared to an IRA.

Withdrawal Rules and Penalties

Both the Traditional IRA and the 401(k) allow you to start taking withdrawals penalty-free at the age of 59 1/2. Any earlier withdrawals come with a mandatory 10% penalty by the IRS (called an excise tax). All withdrawals are also listed as current year income and taxed at the current tax rate. There are some exceptions to the penalty. Please research on your own to see if you would qualify.

Roth IRA contributions (the principal) but not the earnings can be withdrawn after five years tax free. However, restrictions do apply!

Required Minimum Distributions

The IRS has Required Minimum Distributions (RMD’s) for both Traditional IRAs and 401(k) accounts, starting with the year that you reach 70 ½ years of age or, if later, the year in which you retire. That means that you are required to take out a certain minimum percentage each year (and pay taxes on it) and are penalized if you do not.

There are no required minimum distributions at any age for Roth IRAs.

Which One Should I Invest In?

In a perfect world, where you qualify to use both, the answer is just that; both! Every individual and every situation is different. Verify that your employer has a 401(k) and an employer match. See if you qualify for tax deductible contributions to an IRA. Do some of your own due diligence and never hesitate to speak with a financial planning professional. The only mistake you make is in doing nothing.

What are you investing in right now? Leave a comment and let us know!

Last updated by .

Victor

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Comments

8 Responses to The IRA vs 401(k): Which is Right for You?

  • KC @ genxfinance

    As always, to know which one is better for you, you should assess your current situation. You should sit down, gather all the information you can about both plans and see which one will benefit you more.

  • KK @ Student Debt Survivor

    I have a 403B at work. My employer contributes 6% of my yearly salary. Not a bad benefit for a non-profit.

  • Robert Walsh

    There are exceptions to the 401(k) withdrawals before 59.5 penalty. One of the exceptions is “If your separation from service in or after the year you reached age 55 there is no penalty”.

  • Bob Walsh

    The big difference between an IRA and a 401K is that with the 401K you can take distributions penalty free at 55 if you have retired or quit. There is mis-information published on this difference. People are encouraged to rollover their 401K but then you have to pay the penalty if you are younger than 59.5

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