Should you invest your money in a traditional individual retirement account (IRA) or 401(k)? That’s a common question many individuals have when mapping out a strategy to build their nest egg. But before you can make that call, it’s important to understand how each option works and which is best to help you reach your retirement goals.
How Traditional IRA Plans Work
A traditional IRA is a type of individual retirement account that allows you to reduce your taxable income and keep more money in your pocket while boosting your nest egg. Annual pre-tax contributions for 2020 are limited to $6,000, and you can enjoy tax-deferred growth on your earnings. (If you are 50 years of age or older, the IRS permits you to make annual catch-up contributions of $1,000, bringing your total allowable contributions for each year to $7,000).
These plans are best for those who anticipate being in a lower tax bracket at retirement since distributions, which must begin at 70 ½, are subject to taxation. This means you’ll pay less in taxes during the golden years than you would’ve paid had you received the proceeds while still employed. But if you need to take distributions before you reach 59 ½, you’ll be subject to federal income taxation and a 10 percent penalty. So, if you fall into the 22 percent tax bracket and withdraw $35,000 from your nest egg at age 45, you’ll forfeit $11,200 of your earnings.
If you anticipate earning more post-retirement, a Roth IRA may be a better fit since the contributions are post-tax, which means distributions aren’t taxable. Interested in learning more about Roth IRAs and how they differ from 401(k) plans? Check out this comprehensive guide: Roth IRA vs 401(k)
How 401(k) Plans Work
Although there are many similarities between traditional IRAs and 401(k) plans, the latter can only be accessed through your employer. And while traditional IRAs have tons of investment options to choose from, 401(k) plans are a bit more limited, and administrative fees may be slightly higher.
The annual limit for 401(k) contributions is $19,500, and annual catch-up contributions, if you’re 50 or older, are capped at $6,500. However, if your employer offers a match, you have the opportunity to beef up your nest egg if you make the maximum contribution allowed to capitalize on this benefit. Otherwise, you’ll be leaving free money on the table.
To illustrate, assume your gross earnings $50,000 and your employer is willing to offer you a 100 percent match on up to 5 percent of your annual gross income. To take advantage of their match, you’ll need to contribute at least $2,500, which is well under the annual contribution limit.
Contributions made to 401(k) plans are also pre-tax, which means you can enjoy tax-deferred growth and start paying taxes anytime between 59 ½ and 70 when you take distributions. But if you take a premature distribution, you’ll be hit with ordinary income tax (based on the bracket you fall in) and flat 10 percent penalty on the amount distributed.
An important note: if you take an early distribution to purchase a home, you won’t be subject to federal taxation and the 10 percent penalty. While this may seem like a viable option, you want to avoid exhaust all other possibilities with your lender first and try your best to keep your nest egg intact.
Are 401(k) Loans Permissible?
The good news is that you may be able to take out a loan against your 401(k) earnings and dodge a bullet if you’re facing extenuating financial circumstances. While they’re a much cheaper option than borrowing from a bank, you’ll minimize the extent to which compounding interest can work in your favor as long as the loan is outstanding. In other words, it shouldn’t be used as a slush to cover random expenses.
These loans have five-year terms and are limited to the lower of 50 percent of your retirement earnings or $50,000. Even better, there are no loan origination fees, prepayment penalties, or barriers to entry, like credit checks and lengthy applications, since you are technically borrowing against your own money. However, a nominal interest fee does apply, but unlike other loan products, the amount you pay in interest is deposited directly into your account.
Word of Caution: If your employment ends before the loan is paid in full, the outstanding balance will be payable right away. And if you don’t the funds to cover the balance, the plan administrator will classify the remaining balance as a premature distribution and you can move on with your life.
Side-by-Side Comparison of Traditional IRAs and 401(k) Plans
|Retirement Plan||Annual Contribution Limits||Contribution Type||Withdrawals||Minimum Distributions||Penalties|
$1,000 (for catch-up contributions)
|Pre-tax||Taxable||Must be taken by age 70 ½, but can start as early as 59 1/2||10% plus taxes for premature distributions|
$6,500 (for catch-up contributions)
|Pre-tax||Taxable||Must be taken by age 70 ½, but can start as early as 59 ½||10% plus taxes for premature distributions|
Which Retirement Plan Is Best?
Since both retirement plans offer many benefits, one isn’t necessarily better than the other. It just depends on your financial situation. A few questions to ponder when planning out your retirement strategy:
- Does your employer offer a 401(k) plan? If they offer a match, you want to capitalize on the opportunity to receive free money. Contribute the minimum amount to qualify for the employer match and move on to the next question if you’d like to explore other retirement options. But if your employer doesn’t offer a 401(k) plan or if you’re self-employed, you can skip this question and move on to the next bullet point.
- Do you have residual funds to contribute to an IRA? Contribute as much until you reach the annual limit. And if you aren’t participating in a 401(k) plan or are self-employed, you’ll want to make the maximum allowable annual contributions here (unless your post-retirement income will be higher and a Roth IRA will be a better fit).
- Is it necessary to open a Roth IRA? Do you still have funds left over and would like to continue building your nest egg? Consider opening a Roth IRA if your annual income does not exceed $124,000 ($196,000 if married filing jointly), which is the maximum amount permitted by the IRS to participate in this plan.
- Are your assets diversified enough? Proper asset allocation is a must to minimize the risk of loss. Simply put, don’t put all your eggs in one basket or you stand to lose big if the market takes a dip.
The Bottom Line
Both IRAs and 401(s) are beneficial for individuals looking to build their retirement cushion. But if you can’t decide between the two, consider opening both and consulting with a financial adviser to draft up a plan that will work for you in the long run.