SUMMARY: Just over half of working Americans participate in some form of workplace retirement plan—two of the most popular plans being the 401(k) and IRA. Here’s the difference between these two accounts and how to choose which is best for you.
Just over half of working Americans—approximately 135 million of us—participate in some form of workplace retirement plan, the most popular being a 401(k). A common counterpart to this plan is the Individual Retirement Account (IRA), a self-directed savings option that allows for tax-beneficial contributions.
Each of these plans comes in a variety of flavors and has advantages and drawbacks. These depend on many factors, including your current (and future) income level, employer match, and anticipated retirement age.
So which plan is right for you? Or do you even need to choose?
If your workplace offers this option—and especially if they match contributions—jump in with both feet. Any dollars you put in are pre-tax (at a maximum of $19,000 in 2019) and can usually come right out of your paycheck automatically without a moment’s thought. The more you contribute, the lower your taxable income, and taxes on the money aren’t due until you actually retire.
Some employers may offer a Roth version, which takes taxes up front, leaving your withdrawals tax free. The choice comes down to a prediction of your future income level. If your tax rate goes up, then a Roth works to your advantage; if you see it going down, then a traditional 401(k) is ideal.
If you’re considering switching jobs, check the fine print to see how long your current employer requires you to work before you’re fully vested in their 401(k), which can be as much as five or six years. Jump ship early, and you may leave a significant sum behind.
Depending on the details of your employer’s 401(k)—or if it doesn’t offer one—an IRA can be a valuable alternative. It shares many features with your standard 401(k):
- A healthy mix of standard financial vehicles like stocks, bonds, and mutual funds.
- Traditional and Roth versions, the former of which allows pre-tax contributions before retirement, and the latter of which allows tax-free withdrawals after retirement.
One of the primary differences is that contribution limits are significantly lower than those of a 401(k)—$6,000 per year in 2019, although workers age 50 and up can put in an additional $1,000 per year as a “catch-up” contribution.
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There are many reasons to consider using both financial vehicles in your retirement planning.
- You’ve maxed out your 401(k). If you’ve contributed the maximum allowable amount to your 401(k) (or you’re tired of the high fees), an IRA can be a useful supplement.
- You will avoid penalties. If you leave a job and plan to draw down that previous employer’s 401(k) before you reach 59 1/2, you’ll be hit with a 10 percent penalty (not to mention that the compound interest you’ll forfeit). Instead, consider transferring it to an IRA, which often has lower fees. In any situation where you have to transfer a 401(k) balance, be sure to have it moved directly to the new account. If you receive the money first, you’ll lose 20 percent to income tax and potentially an early withdrawal fee if you hold it for more than 60 days.
- You have a better chance of staying in a lower tax bracket. If you plan your distributions strategically, you can draw down your 401(k) without jumping up to a higher tax bracket. An IRA can be a key partner in this as a source of supplemental funds.
If implemented strategically, a 401(k) and IRA together can give your savings a healthy boost. No matter how you plan your retirement savings, take note of the calendar as age 65 approaches. The system has crucial deadlines to meet, which can give you a nice boost if you meet them, but knock you back a couple of steps should you ignore them.Do you have any additional questions about a 401(k) or IRA? Request a free consultation with one of our wealth advisors and we’ll be happy to give you any answers you’re looking for.