Posted by Raven Skylar Tax & Consulting, LLC

IRA vs. 401(k): Which Is Better?

IRA vs. 401(k): Which Is Better?

An Individual Retirement Account (IRA) and a 401(K) are pension accounts with tax benefits. While 401 (k) is typically offered only by employers (which typically match employee contributions), individuals can open IRAs through any retail broker. 401 (k) generally allows for higher contributions. Still, it offers fewer investment options, while IRAs have lower contribution and income limits for high-income earners but offer the flexibility to invest in almost any stocks, bonds, or mutual funds.


IRA vs. 401(k) 

If you are debating between investing in an IRA or a 401(k), the first thing to know is that you don't have to choose. You can invest in both.

Some of the main differences between IRA plans and 401(k) plans include:

  • Account Sponsorship: Most 401(k) are offered by employers, while an IRA can be opened through any retail broker. You don't have to rely on your employer to set up an IRA.

  • Contribution limits: Although the limits change every year, the contribution limit for 401(k) is approximately three times the contribution limit for IRA.

  • Eligibility Rules: There are no upper-income limits for 401(k) contributions, but high-paying employees who earn above certain income limits are not eligible to make tax-deductible contributions to traditional IRAs or to invest in the Roth IRA.

  • Investment options: IRAs opened with large brokers offer a wide range of investment vehicles. In contrast, most 401(k) only offer 20 or fewer investment options (usually in the form of funds mutual funds).

  • Withdrawal rules: Early withdrawal penalties generally apply to 401(k) and IRA plans if you withdraw money before the age of 59½. However, with each type of account, there are several ways to get exemptions from these penalties. And many work plans offer the option to borrow against 401(k) funds, while IRAs do not include this provision.

Let's take a closer look at some of these rules that govern IRAs and 401 (k) accounts.


Contribution limits

A 401 (k) has a significantly higher annual contribution limit than an IRA. For 2020 and 2021, the contribution limits for each type of plan are:

Type of Contribution Limit

IRA

401(k)

Standard annual contribution limit

$6,000

$19,500

Additional catch-up contribution limit for those ages 50 and older

$1,000

$6,500

Total limit for those ages 50 and older

$7,000

$26,000

Data Source: IRS.


Eligibility to make tax-deductible contributions to a traditional IRA is waived for high-income individuals if the high-income individual or their spouse has access to a workplace retirement plan. Even high-income people cannot make Roth IRA contributions unless they use a Roth IRA backdoor strategy.

It is important to note that the annual 401(k) contribution limits apply only to individual contributions and not to those of the employer. For example, if you contribute $14,000 and your employer pays up to $6,000, this is a total annual contribution of $20,000. Still, only your contribution of $14,000 is calculated for the limit—annual membership fee. You can always contribute an additional $5,500.

In 2020, the total annual contribution limit for a 401(k) plan, including employer contributions, was $57,000 for most workers and up to $63,500 for those aged 50 and above. The total annual contribution limit in 2021 is $58,000 for most people and $64,500 for those over 50. The table below shows the maximum total contributions allowed for 2020 and 2021.

Age of Employee

IRA

401(k) Combined Limit for 2020

401(k) Combined Limit for 2021

Younger than 50

N/A

$57,000

$58,000

50 or older

N/A

$63,500

$64,500

Data Source: IRS.


Unfortunately, when you quit your job, you can no longer contribute to the 401(k) plan sponsored by your former employer. Instead, you have to choose between keeping your 401(k) account as is with the company, transferring it to an IRA, or transferring it to your new employer's 401(k) plan.


Withdrawal rules

Because the IRA and 401(k) plan are meant to help you save for years to come, there are penalties for early withdrawals of money. Typically, if you withdraw funds from a 401(k) or IRA before age 59½, there is a 10% early withdrawal penalty. However, there are important differences in the rules governing withdrawals from IRA and 401(k) accounts.

First, you can withdraw money as a 401(k) loan, but not an IRA. The retirement account loan has significant drawbacks but allows you to take advantage of these funds without incurring pre-retirement penalties.

On the other hand, with an IRA, there are several scenarios in which you can withdraw money early without incurring a 10% penalty. The table below shows when it is possible to withdraw money without penalty from each type of account.

Reason for Withdrawal

IRA

401(k)

Becoming totally and permanently disabled

Yes

Yes

Incurring qualified higher-education expenses

Yes

No

Purchasing a home for the first time (up to $10,000)

Yes

No

Incurring unreimbursed medical expenses exceeding 10% of income

Yes

Yes

Paying health insurance premiums while unemployed

Yes

No

Called to active duty as military reservist

Yes

Yes

Leaving your job during or after the calendar year you turn 55

No

Yes

Table Source: IRS.


If you think you can quit your job at age fifty, then a 401(k) gives you more flexibility because of the rule. But if you want your retirement account to cover your education costs, then If you lose your job or as part of the purchase of a home, only an IRA offers these options without penalty.


Cost

The average rate of a 401(k) is 0.45%; however, fees can vary widely depending on the type of investment account.

Because 401(k) plans offer limited investment options, you may be limited to purchasing shares of mutual funds, which typically charge a higher fee than other types of bonds available with the IRA.

In contrast, investments in IRAs usually involve little or no commission. Most brokers don't charge a fee for opening an IRA and have eliminated trading fees. You can compare IRA providers to identify which ones don't charge. Additionally, with a wider selection of investment types, you can also save on commissions by choosing exchange-traded funds (ETFs) for your IRA portfolio.


Flexibility

Most 401(k) plans offer the option of investing in just 20 or fewer mutual funds. A minority of 401(k) plans can now be set up as self-directed accounts, meaning you can invest in many different types of securities just like you would with a typical but self-directed 401(k) account. These are not the norm.

An IRA is more like a typical retail brokerage account because your investment options are not limited. If choosing an unrestricted investment is important to you, an IRA is undoubtedly your best alternative; however, some investors appreciate the simplicity of having only a few mutual funds to choose from, in which case preferably a 401(k). 

Finally, by comparing all the differences between IRAs and 401 (k) accounts, you may decide to prefer one over the other, or you can choose both. Either way, the important thing is that you save now for the next few years and build a diversified portfolio of strong investments to help you get out.


FOR MORE INFORMATION OR TO SEE HOW RAVEN SKYLAR TAX & CONSULTING, LLC. CAN BEST HELP YOU WITH YOUR TAX FILING NEEDS, PLEASE CLICK THE BLUE TAB ON THIS PAGE.


THANKS FOR VISITING.

Raven Skylar Tax & Consulting, LLC
Contact Member