Both 401(k)s and individual retirement arrangements (IRAs) are investment vehicles that allow you to save for retirement. The beauty of these retirement savings accounts is that your contributions are pre-tax, meaning those funds aren’t subject to federal income taxes before they’re withdrawn in retirement.
Whereas 401(k)s and IRAs serve the same purpose, they have significant differences that can influence which one is right for you. Here are five comparisons that can help illuminate which one best serves your situation and financial needs:
401(k): An employer (company, nonprofit organization, governmental agency) or a sole proprietor of a small business can establish these plans. In other words, individuals can’t start these on their own. If your employer offers such a plan and you participate in it, your employer will routinely withhold from your earnings and contribute to your account the amount you determine, with limitations (see below). As far as the work required on your part, it’s usually minimal.
IRA: An individual sets this up with a bank, insurance company or other financial institution, and then adds money to the account as desired, though there are limitations here too (see below). With an IRA, you’re responsible for the account set-up and arranging your contributions.
401(k): Some employers offer to match part or all of what their employees contribute to their accounts. Experts recommend that if your employer provides this, you should take full advantage, as an employer match can greatly increase your retirement account’s value. However, annual contribution limits, which the Internal Revenue Service sets each year, exist. This applies collectively to all 401(k) accounts you might have in a given year. There’s also a limit to the combined contribution of the employee and employer.
IRA: Because an IRA isn’t employer-sponsored, matching contributions aren’t an option.
3. Contribution limits
401(k): The IRS limits contributions to traditional 401(k)s to $18,000 in 2017, though participants age 50 or older at the end of the calendar year can make catch-up contributions of up to $6,000 above the base restriction. The limit for the combined contribution to these accounts (employer and employee) is either 100 percent of the employee’s compensation or $54,000, whichever is less. The latter number jumps to $60,000 if the participant is eligible for catch-up contributions.
IRA: For 2017, the IRS limits IRA contributions to $5,500 — $6,500 if you’re 50 or older — or your taxable income for the year. But you should note that some of those contributions may not be tax-deductible, depending on your income or if you or your spouse participates in a workplace-based retirement program, such as a 401(k).
401(k): According to the terms of the federal Employee Retirement Income Security Act, if you’re married, your spouse automatically becomes your 401(k)’s beneficiary upon your death, regardless of whom you listed as the beneficiary. The one exception is if your spouse previously consented in writing to your naming someone else the beneficiary. If you are single, upon your death the individual you named on your beneficiary form becomes the beneficiary.
IRA: Whomever you designate as the beneficiary will, in fact, become the beneficiary upon your passing. This designation doesn’t require spousal consent.
401(k): You may be able to take out a hardship loan against your 401(k) depending on the plan and if you’re still employed by the employer that established it, says the IRS. Loans must be for less than half of the account balance or, at the most, $50,000. If the plan allows for loans, you generally may take out a five-year loan without penalty — provided you pay it back on time.
IRA: You can’t take out a loan against your IRA, but may access money from your account for a 60-day period via a tax-free rollover. In other words, you may withdraw money from your IRA free of taxes and penalties if you return it to the same or a different IRA within 60 days. Should you fail to do so, the withdrawal is subject to income taxes and a 10 percent penalty if you’re under age 59 and a half.
Determining whether a 401(k) or IRA is best for you may feel overwhelming at first, but knowing a bit more about their major differences can help make the process much easier.