LAST REVIEWED Oct 15 2019 12 MIN READ
By Barbara A. Friedberg
Anyone who’s considered contributing to a retirement account may be overwhelmed with the options. There’s enough information to make the future retiree want to give up. Don’t despair, this article will provide a guide path to your retirement future and help you navigate the rough 401(k) and IRA waters. We’ll talk about the similarities and differences between 401(k)s and IRAs as well as which to invest in, if you can’t afford to max out both.
The IRA and 401(k) share some basic similarities. Both are types of investment accounts that are designed to help you save and invest money for your retirement. While the money is in the account, the investments within grow and compound tax-free. However, early withdrawals are penalized, except under certain circumstances.
Here’s how the tax deferred tax benefit works for 25-year-old Simon:
Simon transfers $1,000 today into his 401(k) or IRA account.
He invests the $1,000 in a diversified stock index mutual fund such as Vanguard Total Stock Market Index Fund (VTSMX).
and capital gains income from the fund are reinvested back into more shares of the fund.
Simon does nothing else with that $1,000 until age 68, at retirement.
His $1,000 initial investment is now worth $22,378 (assume a 7.25% rate of return).
While in the account, Simon paid no taxes on the money invested for retirement. If the money was in a Roth IRA, the withdrawal would also be tax free. In a traditional IRA or 401(k) retirement account, Simon would pay tax when he withdraws the money in retirement. Of course, for a secure retirement you need to invest more than $1,000. In fact, it’s preferable to invest a portion of every paycheck into your retirement account.
How much should you put in an IRA vs. a 401(k)? We'll walk you through the difference between these two types of accounts (and their sub-types) so you can figure out the best place to put your savings.
How does an IRA work? Roth vs. Traditional?
Keep in mind that an IRA (Individual Retirement Account) can be set up and contributed to on your own. A 401(k) needs to be administered by your employer. So if you are a freelancer, unemployed, or your current company does not offer a 401(k), than an IRA is your only option.
There are two common types of IRA accounts. A traditional IRA and a Roth IRA. Both accounts allow your money to grow tax free! Both traditional and Roth IRAs have some similarities:
Both accounts cap annual contributions at $6,000 for 2019 ($7,000 for those over age 50).
Account owners can invest in most types of stock, bond and cash investments including mutual funds, exchange traded funds (ETFs), and individual stocks and bonds within the account.
A Roth IRA contribution is made with after tax income. Roth IRA eligibility phases out at annual income of $137,000 for single filers. The phase-out starts out at $203,000 for married filers. The Roth IRA retirement account has certain benefits that are lacking in the other retirement choices:
There is no required minimum distribution. You never have to withdraw the money and can pass the account on to your heirs.
As long as you are older than 59 ½ or meet the required other requirements, the withdrawals from the account are tax-free.
Contributions to a traditional IRA may or may not be tax-deductible. If you (and your spouse) are not covered by a retirement plan at work, then your contributions into the plan are deducted from your taxable income. Your income level also impacts whether your IRA contribution is deductible or not. Although money held within the traditional IRA can grow tax free, there are other stipulations attached to this type of account; account owners must begin taxable required minimum withdrawals (RMD) from the IRA at age 70 ½.
The following chart lays out the basic characteristics of the Roth versus the Traditional IRA accounts:
|Features||Traditional IRA||Roth IRA|
|Who can contribute?||You can contribute if you (or your spouse if filing jointly) have taxable compensation but not after you are age 70½ or older.||You can contribute at any age if you (or your spouse if filing jointly) have taxable compensation and your modified adjusted gross income is below certain amounts (see 2019.|
|Are my contributions deductible?||You can deduct your contributions if you qualify.||Your contributions aren’t deductible.|
|How much can I contribute?||The most you can contribute to all of your traditional and Roth IRAs is the smaller of:
|What is the deadline to make contributions?||Your tax return filing deadline (not including extensions). For example, you can make 2019 IRA contributions until April 15, 2020.|
|When can I withdraw money?||You can withdraw money anytime.|
|Do I have to take required minimum distributions?||You must start taking distributions by April 1 following the year in which you turn age 70½ and by December 31 of later years.||Not required if you are the original owner.|
|Are my withdrawals and distributions taxable?||Any deductible contributions and earnings you withdraw or that are distributed from your traditional IRA are taxable. Also, if you are under age 59 ½ you may have to pay an additional 10% tax for early withdrawals unless you qualify for an exception.||None if it’s a qualified distribution (or a withdrawal that is a qualified distribution). Otherwise, part of the distribution or withdrawal may be taxable. If you are under age 59 ½, you may also have to pay an additional 10% tax for early withdrawals unless you qualify for an exception.|
What is the deadline to make contributions?Your tax return filing deadline (not including extensions). For example, you can make 2019 IRA contributions until April 15, 2020. When can I withdraw money?You can withdraw money anytime.Do I have to take required minimum distributions?You must start taking distributions by April 1 following the year in which you turn age 70½ and by December 31 of later years.Not required if you are the original owner.Are my withdrawals and distributions taxable?Any deductible contributions and earnings you withdraw or that are distributed from your traditional IRA are taxable. Also, if you are under age 59 ½ you may have to pay an additional 10% tax for early withdrawals unless you qualify for an exception. None if it’s a qualified distribution (or a withdrawal that is a qualified distribution). Otherwise, part of the distribution or withdrawal may be taxable. If you are under age 59 ½, you may also have to pay an additional 10% tax for early withdrawals unless you qualify for an exception.
How does a 401(k) work?
A 401(k) is another type of retirement account, created by your employer for the employee’s benefit. Employees have the opportunity to contribute a portion of their salary into the 401(k) account. The amount of your employee contribution reduces your taxable income. In many cases, employers also match a portion of the employee’s contribution into the account.
A great benefit of the 401(k) over the IRA is the high contribution limits – employees can contribute up to $19,000 per year into their account in 2016 with a catch-up contribution of $6,000 for those over age 50. Add in the employer’s contribution and this is a powerful retirement savings vehicle.
A disadvantage of the 401(k) is that employees are constrained by the available investment choices within the account. In other words, the employer chooses a list of funds within which the investors can invest. Some plans may not offer optimal funds for their employees or offer funds with high fees. Additionally, some 401(k) plans charge employees higher than average fees and expenses.
Here are the basic differences between IRAs and 401(k)s:
More about 401(k)s:
Which Account Should I Invest in if I Can’t Afford to Contribute to Both?
First, if there’s an employer match, always invest in the 401(k) the amount necessary to receive the employer match. This is bolded because its' very important. You don’t want to ignore free employer money.
From there, it becomes a matter of choice:
, you may want to invest as much as you can in the employer 401(k).
If the 401(k) doesn’t offer
and charges administration fees that are high, you may want to switch to a Roth IRA, opened at a discount broker.
If you want greater flexibility in fund choice because you
(or you object for whatever reason), an IRA will allow you to hand pick funds yourself.
There are a few final considerations. Even if you have a 401(k), it can be nice to also have a Roth IRA due to the advantages that the withdrawals from a Roth are tax-free and there are no required minimum distributions. Yet, if you’re in an extremely high tax bracket today, you may benefit from sticking with the 401(k) to cut down on your taxable income. There’s no easy answer to this question, consider your options, strive to invest in both if you can, and if you meet the Roth income eligibility guidelines. If not, weigh the advantages and disadvantages of each type of account.
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Barbara A. Friedberg
Veteran portfolio manager, expert investor, and former university finance instructor. She has authored 3 money/investing books. Friedberg also owns the financial websites RoboAdvisorPros.com and BarbaraFriedbergPersonalFinance.com.