IRA vs. 401(k)

Elizabeth MacBride

Should You Use an IRA or a 401(k)?

Quick Summary:

  • A 401(k) is only offered through your employer. IRAs can be opened by anyone.
  • If your employer offers to match your 401k contributions, you should almost always contribute to your 401k.
  • A 401k allows you to invest more per year, but an IRA may make more sense if your 401K has high fees or limited investment options.

Introduction

Both IRAs and 401ks can help you achieve your retirement savings goals. Which is right for you? The answer is based on a few key factors: 

Understanding 401ks and IRAs

First, it makes sense to understand the differences between the two types of plans.

A 401k is an employer-sponsored retirement plan. It lets you invest your pay, usually in mutual funds or company stock, before taxes are deducted from it. 

401ks are powerful savings tools. The employer match is the closest thing to free money you may see in your lifetime. And the contributions are on autopilot: They are deducted from your paycheck and contributed to your 401k for you. You don't have to wait for the cash to hit your bank account, and then move it to an investment account. The automation means 401ks are very little work. It also makes it much easier for you to save. When the money automatically comes out of your paycheck, you barely miss it. In fact, you can even sign up for automatic escalations, so that your contributions rise as your salary does. 401ks also have those very generous contribution limits, so you can save more in a 401k than an IRA.

The employer match is the closest thing to free money you may see in your lifetime.

You can also leave your 401k with your employer even after you leave a job, based on certain rules, or you can magically turn your 401k into an IRA. (That's called a rollover.)

There are several varieties of IRAs—short for Individual Retirement Accounts. A Traditional IRA is a savings account where you can tuck money for retirement and get a tax break for it. You must pay the taxes on your original contributions and earnings, but only when you withdraw the money upon retirement. That can help you save on taxes if you expect to be in a lower tax bracket upon retirement. A Roth IRA does not offer a tax break now, but you can take distributions tax-free upon retirement. For those who expect to be in a higher tax bracket after retirement, a Roth IRA may be attractive for that reason. The deductibility of Traditional IRAs and contributions to Roth IRAs are subject to income limits.

If you can afford to contribute to both a 401k and IRA, it often makes sense to do so. However, your contributions and whether you are covered by a 401k may limit the tax deduction you can take for contributions to a traditional IRA. Contributions to a 401k will not affect your contributions to a Roth IRA, since they are not tax deductible. 

How Much Can You Contribute to a 401k or IRA?

The maximum contribution for a 401k or self-employed 401k is $18,000 for 2015. Those 50 and older can make a catch-up contribution of $6,000. An IRA has lower contribution limits than a 401(k). The contribution limits for IRAs for 2015 are $5,500 ($6,500 if you are 50 or older).

Take Advantage of Any Employer Match

Many employers with 401k plans offer a match, which does not count toward your contribution limit. If there is a match, it usually makes sense to save up to that point in your 401k before opening an IRA. You can't beat free money.Most employers have varying rules on matching funds. Sometimes it involves vesting (i.e. how long you have been at an employer) or they will offer to match a certain percentage (for every $1 you save, they will add $.50). Make sure to read over the rules, but it’s almost always worth doing.

Watch Out for High Fees

As you decide where to put your money, pay attention to the fees you are paying. Sometimes, your 401(k) may charge very high fees on the mutual funds it offers: In some cases, more than 2% a year. Smaller companies, those with fewer than 100 or 50 employees, are especially apt to have high fees that will cut into your returns over time. In those cases, you may be better off saving in an IRA. To check out the quality of your 401(k) plan compared with plans at other companies of about the same size, check out Brightscope.You should be looking for fees that total less than .75% a year. The average plan fee, which you can get by asking your human relations department, was .91% in 2012, according to a study released in December 2014 by Brightscope and the Investment Company Institute. With an IRA, you have much more ability to find low costs investments. For example, Fidelity has 16 different index funds that offer extremely low expense ratios. 

Make Sure You Have Good Investment Choices

You should also consider the quality of the investments available in your 401k). If there are only a handful of mutual funds, especially high-priced options, you may be better off saving in an IRA. The average number of funds in 401k plans was 25, according to Brightscope and the ICI. 

Keep in mind that quantity does not necessarily equal quality. Some employers may offer dozens of options which sometimes just makes things even more confusing. If your employer offers only a few funds, but they are low-cost, well balanced lifecycle funds, this can be a good choice.

Sometimes companies require investment in company stock. Since your ongoing employment is already tied to the company, tying your retirement to the company’s success can be dangerous. It’s great if you work for Apple, not so good if you worked for Enron 

A typical IRA at a financial services company, on the other hand, gives you access to a broad universe of investment choices. Brokers like Fidelity, E*TRADE and Merrill Lynch offer thousands of mutual funds, stocks, bonds, ETFs and even options.

In all cases, however, you should give special consideration to "target date" or “lifecycle” funds. Offered by many different companies, these funds include a package of diversified, low-cost investments. Target date funds are designed to be the single holding in your entire retirement portfolio. Even better, they automatically adjust their investment mix over time as you age to balance the risk. For example, the Fidelity Freedom funds lets you pick when you want to retire and then it manages everything else for you. Whether you invest in a 401k or an IRA, these can be great investment options.

What Happens When You Leave Your Employer?

When you leave your employer, you can leave your money in your old 401k plan, move it to a new 401k at your new job, or open an IRA and roll your money into it. You won't pay taxes if you roll the money into some kind of retirement plan. You can either move the money directly, or take a check. Even if you take a check, you will still have 60 days of a tax grace period to get the money into a retirement plan to avoid taxes. Most experts advise against leaving your money in your old 401k, because you might forget about it. Before you decide what to do, compare the fees and investment choices in the old plan against the IRA or 401k that you are considering moving to.

A Roth 401k can only be rolled over into another Roth 401k or a Roth IRA.

Other Special Considerations When Comparing An IRA to 401k

  • Some 401ks allow you to borrow money. IRAs do not. The maximum amount that a plan can permit is the greater of $10,000 or 50% of your vested account balance, or $50,000, whichever is less. A 401k can serve as an emergency cash reserve, but most experts strongly advise against taking loans lightly. You will lose a significant amount of investment returns unless you pay the money back right away.
  • Some 401k plans help you save more over time by automatically increasing your payroll deductions as your salary rises. With an IRA, you have to stay aware of whether you are contributing enough.
  • There are two kinds of 401ks, traditional 401ks and Roth 401ks. With a traditional 401k, you can contribute tax-free from your paycheck, but the distributions, including your earnings, are included in your taxable income upon retirement. With a Roth 401k, you pay taxes on the contributions, but withdraw them tax-free on retirement. More and more employers are offering Roth 401ks, but they are still much less common.

The Advantages of Contributing To Both an IRA and 401(k)

One of the great things about a 401k is that you can contribute much more pre-tax and than you can in an IRA. You can save more in a 401k. As we mentioned above, the maximum contribution for a 401(k) or self-employed 401k is $18,000 for 2015. Those 50 and older can make a catch-up contribution of $6,000. An IRA has lower contribution limits than a 401k. The contribution limits for IRAs for 2015 are $5,500 ($6,500 if you are 50 or older). Your contribution cannot exceed your taxable compensation for the year. 

If you can afford to contribute to both a 401k and an IRA, it probably makes sense to do so: You will save more for retirement than either account would provide for alone. Employed people under 50 generally can save up to $23,500 if they have both a 401k and one or more IRAs.

If you’ve contributed the maximum you can to a 401k (good for you!), you can still contribute to an IRA. However, if your income is more than $71,000 ($118,000 if you are married), the contributions aren't tax deductible. That means it may be more to your advantage to save in a Roth IRA if you have maxed out your 401k. If you have a spouse who doesn't work outside the home, you may be eligible to open a spousal IRA and make tax-deductible contributions to it.

Who Can Invest in a 401k?

You can open an IRA, as long as you will be younger than 70 1/2 at the year’s end, if you are working or receive long-term disability benefits. If you do not have a paying job, but your spouse has taxable compensation, you can still open an IRA.

You can only participate in a 401k if your employer offers one, whereas most anyone can open an IRA (LINK: see more on Traditional IRA rules and Roth IRA rules).

If you own a business, you may have a few other options. You can open and contribute to a solo 401k plan or a solo Roth 401k plan. Because you are contributing as both employee and employer, your contribution limit is higher. Not counting catch-up contributions for those age 50 and over, you can contribute $52,000 for 2014 and $53,000 for 2015.

Instead of a 401k plan for yourself and your employees, you can open a SIMPLE IRA plan. With a SIMPLE IRA, the employee may defer up to $12,000 in 2014 and $12,500 in 2015. Employees age 50 or over can make a catch-up contribution of up to $2,500 in 2014 and $3,000 in 2015. 

As an employer, you must match each employee's salary reduction contribution on a dollar-for-dollar basis up to 3% of the employee's compensation. Or, you can make contributions of 2% of the employee's compensation up to the annual limit of $260,000 for 2014 or $265,00 for 2015. If you own your own business, opening a SIMPLE IRA can be a good way of saving a lot of your income tax-free.

An IRA has lower contribution limits than a 401k. The contribution limits for IRAs for 2015 are $5,500 ($6,500 if you are 50 or older). Your contribution cannot exceed your taxable compensation for the year. 

You can save more in a 401k. The maximum contribution for a 401k or self-employed 401k is $18,000 for 2015. Those 50 and older can make a catch-up contribution of $6,000. 

For those with a self-employed 401k, it is also possible to save up to 25% of their compensation, depending on their income, in a profit-sharing plan. They can save up to $53,000 for 2015, a total that includes the money contributed to the self-employed 401k.

If you have a SIMPLE 401k plan, the maximum contribution for 2015 is $12,500.  The catch-up contribution for those 50 and older for 2015 is $3,000.

The Bottom Line

While all retirement plans have their pros and cons, you are better off using one than not saving at all. Get started today and you’ll be on your way to a more secure retirement. 

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Important IRA Information

Each year, the IRS updates the rules for Traditional IRAs. Here are all the details for 2015: