Which is the better choice for retirement saving, an IRA or a 401(k)? And what’s the difference between the two?
Either an IRA (Individual Retirement Account/Arrangement) or a 401(k) plan is a great place to start investing for retirement. They are more alike than different, and which one to choose depends on your particular circumstances. Here are some of the basics you need to know.
1. Who can use these plans?
You can open an IRA if you or your spouse has income earned from working. This includes wages, commissions, and self-employment income but not income from sources like rental property or pensions.
Since 401(k)s are only offered through employers, these plans are not available to everyone. IRAs can only be opened by individuals and are never available through employers.
2. How much can you contribute?
For 2014, the maximum annual contribution for an IRA is $5,500, or $6,500 if you’re 50 or older. The maximum annual contribution for a 401(k) is $17,500, or $23,000 if you’re 50 or older. Spouses eligible to participate in their own plans can each contribute the maximum.
3. Is there employer matching?
With an IRA, no. But many employers match part of employees’ contributions to 401(k) accounts. This is why a 401(k), if available, is often the best place to start your retirement saving. Part of the money you put into the account is doubled even before it earns any kinds of investment return.
4. What about taxes?
With a traditional IRA or 401(k), all or part of the contributions you make are usually tax-deductible but you pay taxes on the money you withdraw at retirement. The money you contribute to a 401(k) is not taxed; it is taken out of your paycheck before tax withholding is figured. Any matching 401k contribution from your employer is not taxed, either. You do pay taxes on the money you withdraw.
If you choose a Roth IRA or 401(k), your contributions are not tax-deductible. However, the money you withdraw after retirement is not taxed.
With both traditional IRAs and 401(k)s, if you withdraw funds from the account before age 59 1/2, you generally have to pay taxes on that money, plus a penalty of 10% of the amount withdrawn.
5. What if you leave a job and have money in a 401(k)?
Any money you have contributed, plus its earnings, is yours. Usually you have to stay with a company for several years before the employer match is fully vested, meaning it’s yours to keep even if you change jobs. You can roll over the amount in your account to an IRA or to a new employer’s 401(k) without paying penalties. This rollover amount doesn’t count toward your annual contribution limit.
6. Is a 401(k) or an IRA a better investment?
This is something that confuses a lot of people. Neither IRAs nor 401(k)s are investments in themselves. Instead, they are accounts, serving as containers to put investments in. A 401(k) plan will usually have several different investment options to choose from. IRAs typically have many more investment options. My advice is to pick mutual funds that include the greatest variety of asset classes like US stocks, international stocks, US bonds, international bonds, real estate, and natural resources. In either an IRA or a 401(k), it’s wise to diversify your retirement funds among as many asset classes as you can.
In sum, either a 401(k) or an IRA is a good retirement savings choice. Some taxpayers can contribute to both. What matters most is choosing to make regular contributions to a retirement account in order to provide for your future.
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