IRA vs. 401K, What You Need to Know

You may just be starting to think about saving for retirement, or you may already be contributing to one or both of these types of accounts, but there are significant differences between IRAs and 401Ks that you should be aware of before deciding on which one you want to help build your savings. You may find that you qualify for one or both of these accounts and need help deciding which one to use for retirement, if not both. The biggest differences between IRA and 401K accounts are listed below.

  • Qualification. Anyone can contribute to a traditional IRA as long as they are younger than 70 ½ years old. A Roth IRA requires a person make less than $117,000-132,000 in income annually, or less than $184,000-194,000 if married and filing a joint tax return. A Roth IRA also has no age requirement. For a 401K, you must work for an employer who provides 401K plans to their employees. Based on just these facts, you may already qualify for one or all three options. Read on to find out which one is best for you and your needs.
  • Contributions. A traditional IRA and a Roth IRA allow you to contribute $5,500 per year, or $6,500 if you are 50 or older, to it as long as your income exceeds the maximum amount. If you earn less than $5,500 per year, you can only contribute up to the full amount of your income. A 401K on the other hand allows you to contribute up to $17,500, as long as your income equals or exceeds the amount you contribute. Your employer may also offer a matching incentive for a 401K that will help you save more money more quickly.If you can afford to contribute more than $458.33 per month to your retirement and your company offers a 401K option, it might make sense to save through this alternative to make up the difference. However, you’ll have to decide between this being your only account or if you want an IRA or Roth IRA to be the primary account and the 401K a backup for excess saving. If your employer match is generous enough, you may want a 401K as your only account if the free employer money exceeds the tax break you would receive with an IRA. Your goals for taxation will help you make your decision.
  • Taxation. With retirement funds, you can either choose to have a tax break now or waive the withdrawal taxation later, but unfortunately you can’t enjoy both. Traditional IRA contributions are tax deductible every year, but withdrawals later on will be subject to an income tax. Roth IRA contributions cannot be used for yearly tax deductions, but withdrawals are also exempt from taxation in the future. A 401K contribution is taken directly from the employee’s paycheck, either pre-tax or post-tax. If it’s post-tax, you don’t have to worry about paying taxes on the contribution that year, since you already paid income tax on it. The only other time you are taxed on a 401K is when you make a withdrawal.
  • Distributions. When it’s time to make a withdrawal, called a “distribution”, each account has different rules. To avoid unnecessary penalties from withdrawing too early, it’s best to wait until you’re at least 59 ½ before receiving your first distribution, no matter what account you have. Once you hit 70 ½, you will be required to take your first minimum required distribution with a traditional IRA and a 401K. If you don’t, you will incur significant penalties. Roth IRAs have no required distribution schedules.
  • Investments. With a 401K, your company will provide a preset list of investment accounts you can hold your retirement in, each one having a different level of risk associated. With IRAs and Roth IRAs, there are an infinite amount of accounts that you personally will be able to decide where to keep your funds; but some have restrictions or limitations, so you may not qualify for all of them.

As you can see, IRAs and 401Ks both have costs and benefits, and only you can decide which one, if not both, fit your personal situation. One option may earn you more money in the long run, or cost you less in taxation, so it’s critical to do your own research before deciding. No matter which option you choose, saving for retirement early and consistently is always the best strategy.

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