Both a 401(k) and an individual retirement account can be used to save for retirement. If you want to set aside funds for the future, but aren’t sure which option to choose, it can be helpful to understand the pros and cons of each type of retirement account.
Here is a look at what’s involved with saving for retirement in a 401(k) and an IRA, along with some of the key differences between the two accounts.
How a 401(k) Works
You’ll only be able to access a 401(k) if it is available through your employer. Some companies also require their employees to work for a certain period of time, such as a number of months or a year, before gaining eligibility for this type of account. “A 401(k) plan, also known as a defined contribution plan, allows employees to contribute a percentage of their salary to a company sponsored plan,” says Mike Piershale, president of Piershale Financial Group in Barrington, Illinois.
With a 401(k), contributions are usually made through payroll deductions. This means you can have an amount taken out of each paycheck and set aside in the account. In addition, some companies offer to contribute to 401(k) plans on behalf of eligible employees. One common type of employer contribution is a 401(k) match, and the amount you receive will depend on company policies. “A matching contribution will typically be between 2% and 10% of the employee’s income and will be contingent upon a certain level of participation by the employee,” says Rob Drury, executive director of the Association of Christian Financial Advisors in San Antonio, Texas.
Every year, the IRS places limits on how much you can contribute to a 401(k). In 2021, if you are younger than 50, you can deposit up to $19,500 in a 401(k) account. If you are 50 or older, you can place an additional $6,500 in the account, for a total 401(k) contribution of $26,000. There may be some limits for highly compensated employees, as determined by the IRS.
As you contribute to the account, you can choose how to invest the funds. “Participants in a 401(k) are limited by the investment options set up by the plan, generally a range of mutual funds,” says Syed Nishat, a partner at Wall Street Alliance Group in New York City. You’ll also find that fees can vary, depending on the 401(k) plan your company offers. If you’re not sure what the costs are to manage your account, ask to see a list of fees.
You’ll typically need to wait until age 59 1/2 to withdraw funds to avoid penalties. If you take out money before age 59 1/2, you could be charged a 10% penalty on the amount withdrawn and have to pay taxes on the withdrawal. However, there are some exceptions to the early withdrawal penalty. If you leave your job at age 55 or older, you can take penalty-free withdrawals from the 401(k) account. After age 72 you will usually face required minimum distributions, but you may be allowed to delay required distributions if you are still working.
Some employers offer both a traditional 401(k) and a Roth option. With a traditional 401(k), taxes are not paid on the amount deposited into the account, and withdrawals are considered taxable income. You deposit after-tax dollars in a Roth account, but you generally won’t need to pay taxes on the distributions in retirement.
[Read: How to Rollover Your 401(k).]
How an IRA Works
To be able to set up and contribute to an IRA, you must have earned income. However, there are some exceptions. For instance, if you are married and file your tax return jointly, you can contribute to a spousal IRA for a nonworking spouse. There are also limits related to your income. “Once your modified adjusted gross income gets over $140,000 for a single person or $208,000 for a married couple filing jointly, you cannot buy a Roth IRA,” Piershale says.
If you have an IRA and have not yet turned 50, the IRS allows you to place up to $6,000 in the account in 2021. If you are 50 or older, the IRA contribution limit is $7,000. You can choose how you would like to invest the funds. “For an individual opening an IRA, there are many choices, as the account owner can invest in whatever they decide they wish to hold, including bonds, stocks and other vehicles,” Nishat says. You may ask an advisor to help sort through the options and fees.
There are two types of IRAs: traditional and Roth. With a traditional IRA, you won’t pay taxes on the amount you put into the account, but withdrawals will be subject to taxes. You usually need to be at least 59 1/2 years old to withdraw funds without having to pay penalties. If you withdraw funds before then, you could have to pay a 10% penalty on the amount withdrawn, plus taxes on the withdrawal.
If you save for retirement in an after-tax Roth IRA, you’ll pay taxes on the amount you contribute to the account, but withdrawals in retirement generally won’t be subject to taxes. You can take out contributions made to the account at any time, provided the account is at least five years old. You’ll need to wait until age 59 1/2 to withdraw earnings accumulated in the account if you want to avoid penalties. Roth IRAs do not require you to start taking distributions at a certain age.
Both traditional and Roth IRAs include several early withdrawal penalty exceptions. You may be able to take penalty-free withdrawals for a variety of specific circumstances, including health insurance after a layoff and college costs.
Key Differences Between a 401(k) and an IRA
While there are some similarities between 401(k)s and IRAs, they each have unique features as well. The major differences between 401(k)s and IRAs include:
— Anyone with eligible earned income can open an IRA, but a 401(k) is only available through an employer.
— A 401(k) has a higher contribution limit than an IRA.
— A 401(k) may provide an employer match, but an IRA does not.
— An IRA generally has more investment choices than a 401(k).
— An IRA allows you to avoid the 10% early withdrawal penalty for certain expenses like higher education, up to $10,000 for a first home purchase or health insurance if you are unemployed.
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Update 03/31/21: This story was published at an earlier date and has been updated with new information.