IRA vs 401k? Choose Both, Contribute Wisely
IRA or 401k? The answer is simple. Both
Defined contributions have largely replaced defined benefits such as pensions. These retirement plans involve either the employee or the employer contributing a predefined amount on a monthly, quarterly, or monthly basis. Two common defined contribution retirement plans are IRAs and 401(k)s. Both of them tax-advantaged retirement savings.
What is a 401(K)?
401(k)s, along with 457s and 403(b)s are qualified "employer-sponsored" retirement plans. The money which employees contribute towards their own 401(k) plan is pre-taxed. This means that the amount does not get taxed in the year the individual receives it. Employees have to pay taxes upon retirement when they withdraw the plan.
What is an IRA?
IRA stands for Individual Retirement Account. Any individual can contribute towards a traditional IRA, which offers tax-deferred growth on their investments. Another type of IRA is a Roth IRA which offers tax advantages opposite of a traditional IRA. In retirement, holders do pay any tax on withdrawals from either the earnings or the contributions.
Employees can have a hard time when choosing between an IRA and a 401(k). They may face two circumstances: when the employer matches a 401(k) and when an employer doesn’t.
Does Your Employer Offer 401k Match?
Employers can choose to match the 401(k) contributions made by an employee, based on his/her annual contribution amount. Employers generally match a percentage of the employee contributions up to a certain portion of their salary.
The terms and conditions of different 401(k) plans may vary, with the sponsoring employer determining the specific terms of each plan. However, certain necessary directives set by the Employee Retirement Income Security Act, have to be implemented. This can include withdrawal regulations and certain required contribution limits.
Employers can either choose not to match the employee contributions, or to choose a generous formula to match the plan. Regardless of the nature of the match, employees should not lose out on this essentially “free money”. When an employer makes a matching contribution. Employees should refer to the terms of their plan for verification.
If An Employer Offers Matching:
Invest amount that leads to maximum match:
One of the biggest benefits of having a 401(k) is a company matching program which can be subject to a limit. There are multiple ways how employers can impose limits on matching employee contributions. The employer may choose to match a percentage of contributions up to a particular limit or may match 100% of the contributions up to a percentage of the employee’s total compensation. Even though the total limit on employer contributions remains unchanged, the first option results in the employee contributing more to the plan in order to receive the maximum match. There are some employers who just match up to a certain dollar amount, regardless of the employee’s income.
To understand how matching works, here is an example. An employer is offering to match 100% of all the employee’s contributions each year up to a maximum of 3% of the employee’s annual income. The Employer would contribute $1800 in case an employee earns $60000. This also requires the employee to contribute $1800 to maximize this benefit. Any additional contributions beyond the particular percentage are unmatched.
Many Employers also follow a partial matching scheme with an upper limit. For example, an employer can match 50% of the employee’s contributions up to 6% of their annual income. Thus the same employee earning $60000 would have to contribute 6% of their salary, i. e. $3600. However, since the employer is only matching 50%, their total matching benefit is limited to $1800. Under this approach, employees have to contribute twice as much money to take advantage of employer matching.
It's a fact that all deferrals are subject to an annual contribution limit. This is usually dictated by the Internal Revenue Service or IRS. As of 2020, the total contribution limit is $57000 for all 401(k) accounts of the same employee, regardless of his/her employment status.
- Contributing as much as allowed to IRA:
Employees are allowed to choose between two types of IRAs, Traditional or Roth. Depending on this decision, employees may get a tax break either when they start withdrawing the funds upon retirement or get a tax break instantly.
Traditional IRA: Getting a traditional IRA is ideal for receiving a tax break immediately. Normally, these contributions may be deductible. However, if an employee is covered by a 401(k), their deductions may be eliminated or reduced.
Roth IRA: Roth IRA’s can be ideal for individuals who do not mind surrendering the IRA’s immediate tax deduction, or those who aren’t eligible for deduction in traditional IRA contributions. There are income limits on Roth IRA. However, employee participation in the Roth IRA is not affected by participating in a 401(k).
Push limit on IRA contribution and move back to 401(k):
After an employee has maxed out on an IRA, he/she should revisit their 401(k). Despite the many limitations that exist, a 401(k)’s tax deductibility is its main advantage. The money the employee contributes would lower his/her taxable income for the specific year. In addition, they also have the advantage of tax-deferred growth on gains from investments.
If an Employer Doesn't Offer to Match
First, contribute towards traditional or Roth IRA: There are many companies that choose against matching retirement account contributions that their employees make. Employees facing such a scenario may consider choosing an IRA and contribute to the maximum. This is because of the unlimited types and number of investments that an IRA offers. Employees can gain more control over their own investment options. Instead of the limitations present in the investment offerings under a workplace retirement account, employees can bargain shop for low-cost ETFs or index mutual funds. They can also avoid paying the administrative fees associated with 401(k) plans.
Max out IRA benefits and contribute towards 401(k): After an employee funds a traditional or Roth IRA, the deferral benefit that a company-sponsored plan provides is a good reason to invest in a 401(k). It’s never advisable for an employee to completely avoid their company plan except when the plan involves high administrative costs or high-fee choices for investments.
It should be noted that the employee’s ability to deduct traditional IRA contributions may be eliminated or reduced. This depends on whether the employee or his/her spouse contributes money into a workplace plan, or if his/her income passes over a certain threshold. Individuals not eligible for traditional IRAs may still be eligible for a Roth IRA. Individuals can still make contributions that are non-deductible, even if they’re not eligible to deduct their own traditional IRA. Additionally, employees can convert a traditional IRA into a Roth IRA by using a back-door IRA.
When Can You Ignore 401(k)s?
Employees should take their company 401(k), because of the benefits they provide. However, there are certain instances where employees should ignore their 401(k)s, in spite of them being a crucial part of their benefits package. The investment risk, in this case, is borne by the employee him/herself.
It may so happen that the employee’s company comes up with a less than favorable company plan. It may include limited investment options, sky-high management fees, or investment options that only have high fees associated with them. Under such circumstances, the employee can choose to ignore a 401(k) plan.
The Bottom Line
Both 401(k)s and IRAs are great options when it comes to saving for retirement, in spite of their own set of restrictions. For employees, a great way to grow their investments is to contribute to either one of these options. Employees should also always consider maxing out their contributions if they have eligibility for an employer match. Employees should consider cost and flexibility as main considerations when they choose between a 401(k) and an IRA.