For those who qualify, IRAs and 401ks are some of the best investment vehicles out there for retirement. Ideally, if at all possible, both should be maxed out annually. However, it is far from a perfect world, and people need to make choices. 401k vs. IRA may be one of them.
With all 401ks offer, everyone who qualifies needs to use them to their full advantage. This is especially true when the employer matches funds, since it is literally free money.
The other big advantage of a 401k is that the money contributed to it (pre-tax) will be free of Federal income tax until retirement (if it is not withdrawn before then). This means that the full amount can be invested and put to work for retirement. In addition, every penny of any returns earned will compound and grow more quickly over time since nothing is being lost to taxes.
Furthermore, unlike the relatively low annual contribution limits placed on IRAs, 401ks allow much more to be saved. They also offer the ability to borrow from them in times of need. There are no penalties for doing this as long as the money is paid back.
401ks and their disadvantages vs. IRAs
The wages and put into and returns earned from 401ks are tax deferred but not tax free. When the money is withdrawn on retirement, it will be taxable. However, most people are in much lower tax brackets in their retirement years. In addition, the fact that the money could grow before being taxed makes a big difference.
Another problem is that 401ks are complex plans that need to be administered. Unlike IRAs that are marketed nationally, the investment options are limited. People have to take what is offered, and administration costs are higher. Look at the fees and investment options carefully. Be sure to diversify as much as possible. Never forget the lessons of Enron in which people lost their entire savings when they had everything invested in a single company’s stock.
Another point to consider is that 401ks have requirements as to when the money must be withdrawn. Unless the holder is still employed, they must begin withdrawing at 70.5 or face penalties.
IRAs and their advantages
There are two major types of IRAs, and they are very similar in most ways apart from how they are taxed. While a traditional IRA is tax deductible (although limits apply based on whether one is covered by a retirement plan at work and income level), a Roth IRA is not. The returns on both IRAs will compound tax free. However, a Roth IRA has the major advantage over both a traditional IRA and a 401k when distributions are taken. In addition to the principle, all earnings a Roth has generated over its lifetime will be tax free.
There is much greater choice with IRAs. The market for IRA money is competitive, and the options are diverse. People can choose their investments, and the fees are lower than those for 401ks. They can also transfer IRAs relatively easily to other institutions that may have better offers.
While traditional IRAs have the same requirement to begin taking distributions at 70.5 as a 401k, there are none for a Roth.
Another neat feature of IRAs is the ability to contribute any time during the year. In fact, it is possible to make retroactive contributions for the previous year up to the filing date. Therefore, one can contribute in April for the previous tax year.
Roth IRAs generally have fewer restrictions overall.
Disadvantages of IRAs vs. 401ks
The contribution limits for IRAs are much lower than those for 401ks. A look at the limits and other rules governing 401ks and IRAs can be found here.
Those over certain income levels are not allowed to contribute. In addition, one must have earned income to be eligible to contribute.
Things to keep in mind
When looking at the relative merits of IRAs vs. 401ks, there are some things to keep in mind for both.
- Start early: The major advantage of all of these investments is the ability to have the money compound tax free. Even a relatively modest contribution at a young age can really add up over time. While this is true for any retirement savings, it is especially true with these investments.
- Remember market trends and diversify: To really see money in an IRA or 401k grow, it is necessary to take some risks in stocks. Markets can certainly drop over the short term, and the short term may last for years. However, historically, diversified investments in stocks almost always pay off the long term.
- Keep the money in until retirement: Each program has different rules on withdrawing the money early. Regardless of the penalties, avoid the temptation to withdraw any of the money before retirement if at all possible.
- Check with the IRS website for rules and regulations since rules will vary with income, etc. and contribution limits as well as other factors are constantly changing.
With everyone at different income levels and ages, there is no single answer for those wondering which is best when comparing a 401k vs. a Roth IRA. As a general rule, particularly for younger workers, it is a good idea to max out a Roth once all employer matching funds have been received for the year.
Once retirement comes, being able to take distributions tax free is certainly a huge bonus so younger workers need to do what they can to max out their Roth’s. In addition, keep in mind that it is often possible to roll over a 401k into a Roth. This option should be considered when available.