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 what’s involved with each.
When comparing these retirement accounts, you can look at:
— Key differences between a 401(k) and an IRA.
— What is a 401(k)?
— 401(k) pros and cons.
— What is an IRA?
— IRA pros and cons.
— Should you have a 401(k), an IRA or both?
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. 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.
What Is a 401(k)?
A 401(k) is a type of retirement plan available through your employer. Some companies require 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.
[READ: How Much Should You Contribute to a 401(k)?]
How 401(k) Contributions Work
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.
2023 401(k) Contribution Limits
Every year, the IRS places limits on how much you can contribute to a 401(k). In 2023, if you are younger than 50, you can deposit up to $22,500 in a 401(k) account. If you are 50 or older, you can place an additional $7,500 in the account, for a total 401(k) contribution of $30,000. There may be some limits for highly compensated employees, as determined by the IRS.
How to Withdraw From a 401(k)
To avoid penalties, you’ll typically need to wait until age 59 1/2 to withdraw funds. 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 401(k). 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.
401(k) Pros and Cons
If you use a 401(k) as part of your retirement strategy, you could benefit from the higher contribution limits. For those with employers who make matching contributions, the savings can add up over time. The account also offers some flexibility. If you aren’t able to save one year, you might be able to add more later. You could also take hardship withdrawals if an unexpected event occurs.
However, these plans could include higher fees and fewer choices. “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. If you take early withdrawals and don’t qualify for a hardship, you will face fees on the amount taken out.
What Is an IRA?
An IRA is a retirement plan you can set up if you have earned income. You’ll be able to contribute a certain amount every year if you meet the requirements. There aren’t required distributions from the account, so you could also keep investments in place over time.
[Read: IRA Rules: Contributions, Deductions, Withdrawals.]
2023 IRA Contribution Limits
If you have an IRA and have not yet turned 50, the IRS allows you to place up to $6,500 in the account in 2023. If you are 50 or older, the IRA contribution limit is $7,500. 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. If you file taxes as a single person and have a modified adjusted gross income of $153,000 or more a year, you won’t be able to contribute. For married couples filing jointly, the income limit is $218,000.
Types of IRAs
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. The contributions will be deducted from your income. The money will grow tax-free in the account over time. When you take withdrawals later, they will be subject to taxes.
If you opt for a Roth IRA, you’ll put after-tax dollars into the account. The contributions and interest will grow over time. When you access the funds, the amount won’t be subject to taxes.
How to Withdraw From an IRA
For a traditional IRA, 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 can take out contributions made to the account at any time, provided the account is at least five years old. To avoid penalties, you’ll need to wait until age 59 1/2 to withdraw earnings accumulated in the account.
Both traditional and Roth IRAs include several early withdrawal penalty exceptions. You may be able to take penalty-free withdrawals for a variety of circumstances, such as to cover health insurance after a layoff and college costs.
IRA Pros and Cons
With an IRA, you may appreciate the selection and flexibility of the plan. “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.
There are some drawbacks to IRAs. The amount you can contribute is less than other retirement plans. If you earn too much, you won’t be able to make contributions. You could pay early withdrawal penalties in some cases if you take out funds and aren’t eligible for a fee exception.
[See: 12 Ways to Avoid the IRA Early Withdrawal Penalty.]
Should You Have a 401k, an IRA or Both?
If you work for a company that offers a 401(k), ask about the plan. You’ll want to find out if a match is available, plus whether all employees are eligible or if you need to work for a certain number of hours or years to start contributing to the plan. Choosing to have funds withdrawn directly from your paycheck could be a way to save in a regular, automated way.
Getting an IRA may add some flexibility, as you could choose which investments you’d like to make and keep funds in the plan. You’ll also be able to access the account without penalties after five years, which provides an extra layer of flexibility and security.
Whether you get one account or both is a personal decision. Consult a financial professional to help you decide the best fit. If you’re close to retirement and want to max out your savings options, contributing to a 401(k) and an IRA could be a great choice.
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IRA Versus 401(k): Which Is Better? originally appeared on usnews.com
Update 09/11/23: This story was published at an earlier date and has been updated with new information.
