401k vs IRA : decide which is best for you

401k vs IRA: make a comparison to decide which one is best for you? You are planning for your retirement, but you are not familiar or confused about which retirement plans is best for you. You can find helpful guidelines here.  

Retirement accounts are set up for the purpose to make sure you have enough money when you retire. You can take advantage of tax deductions. However, you should set your emergency fund aside and should not put all of your money in retirement. It is usually hard to withdraw and you have to pay a penalty for pre-retirement distribution. 

 401k and IRAs are both contribution retirement accounts. However, they are different. Both have advantages and disadvantages.

You can split your contribution into both 401k and IRA.

In order to have a better comparison between 401k and IRA, you should know what is 401k and IRA as well as their advantages and disadvantages.

What is a 401K? 

A 401k is a defined contribution plan which is offered by your employer. 

There are 2 types of 401k plan which are traditional 401k and Roth 401k.  They have similar features. However, traditional 401k is a pre-tax contribution which helps to lower your tax rate at the current tax year of contribution, but you pay tax later for distribution. Unlike traditional 401k, Roth 401k is a post-tax contribution. So you do not take tax benefits when you contribute. However, your Roth 401k distribution is tax free.

Advantages of 401k 

1. No income limit to participate: There is no required income limitation to participate in 401k (applies to both traditional 401k and Roth 401k) 

2. Employer matching up contribution: Your employer may match up your contribution. Different companies have different rules for matching up contributions. You do need to meet the vesting period to vest your contribution portions. 

For example, you contribute $5000 into your 401k plan. Your employer can contribute 60% per year on $5,000 you contribute. It means your 401K account has $8,000. However, the company may have rules that your employment period at the company must be at least 5 years to vest 100% contribution. 

3. Low risk investment choices: Employers usually offer low risk investment choices for 401k such as mutual funds. If you are a low risk tolerant investor, you may prefer to invest in those low risk investments.

4. Arranged Investment choices: Your employers offer arranged investment choices. Then, you choose to invest within what the employer offers. It is a good option if you don’t feel comfortable to make your own choices beyond what your employer offers.

5. Loan : You are legally allowed to loan your 401k (s) up to $50,000 or 50% of the total contribution, whichever is lesser. However, you have to pay back within 5 years to avoid tax and a 10% penalty if you are under 59 ½ .  

Disadvantages of 401k

1. More rules: 401k (s) have more rules both on the company and IRS. The company may limit the times of rebalancing your portfolios. The IRS requires that 20% of distributions from a 401(k) be withheld for federal taxes.

2. May not be easy to communicate: In a bad case, your 401k can be frozen for some years when your employer or former employer goes bankrupt. This situation will cause drawbacks for your retirement account. 

3. Limit on Investment choices: Employers have arranged investments for employees to choose. Those are usually mutual funds, target date funds (a mixture of  stocks and bonds), guarantee investment contracts issued by insurance companies and may be the employer’s own stock which are low risk, but also have a low rate of return. 

 Hence, you have to invest in specific investments that the employer offers. You cannot invest in something beyond the employer’s choices. 

4. Vesting periods: It is nice that your employer offers matching up contributions. However, you should pay attention to the employer’s vesting rules. 

Your employer has vesting rules. For instance, employees can vest only 20% after 1 year of working, 40% after 2 years, 60% after 3 years, 80% after 4 years and 100% after 5 years. It means that if you decide to leave the company earlier than 2 year of working, your 401k includes only your contribution, but does not include the employer’s matching up contribution.

In case, you leave the company after 2 years, then you can vest 40% of the company matching contribution on top of your own contribution. . 

5. Some employers may not match up your contribution. In this case, your total account is what you contribute and investment growth.

6. Contribution limit: 401k contributions have limits. In 2021 limits $19,500 per year for employees under 50, $26,000 for those age 50 and up (including $6,500 catch up contribution).

The total contribution (both from your contribution and employer’s contribution) for 2021 is capped at $58,000 or 100% your compensation, whichever is lower if age under 50 and $64,500 for age 50 or over.

7. Penalty on pre-retirement withdrawals: You have to pay an additional 10% non-qualified distribution penalty plus other tax you own. 

Otherwise, You must be at least 59 ½  to withdraw or have to meet IRS criteria such as totally or permanently disabled to withdraw without penalty.

8. Required minimum distribution (RMDs): In 2021, RMDs are required when you are 72 years old. You are required to follow RMDs rules to avoid a 50% penalty on any missed RMDs after age 72. 

What is an IRA?

IRA is an individual retirement account. You open it through banks, brokerage accounts such as Fidelity, Charles Swabs or investment firms. Also, you put your own contribution and make your own investment decisions. You can rollover your contribution from your previous employer after you leave the company.

There are 2 types of IRAs. They are Traditional IRA and Roth IRA. Similar to traditional 401k and Roth 401k, both have advantages and disadvantages.  

Advantages of IRA

1. Flexible investment choices: You make your own contribution and your own investment decisions. So, you can have variable investment choices for your retirement.

In this case, your investment return can be higher, but it also comes at a higher risk.

2. Easy communication: You basically manage your portfolios with your own investment rules and decisions. 

3. Low cost: Many companies such as Fidelity, Charles Swabs, Merrill Edge and so on offer unlimited trading and without fee with stocks, ETFs and mutual funds trading. 

4. Cash incentives: Some companies such Fidelity, TD Trade, Merrill Edge  may have cash incentives when you open a new IRA or rollover your retirement accounts from former employers to IRAs. The cash incentive amounts may vary depending on your account amount. 

5. No penalty and tax free on pre-retirement contributions that meet IRS criteria. 

Roth IRA contributions can be withdrawn up to your contribution and it is tax free. It can be withdrawn any time for any reason without penalty. Earning withdrawals on Roth IRA are tax free and with no penalty if your account is at least five years and you have at least one of these circumstances: 59 ½ years old or above, permanent disability, deceased.

6. No requirement for minimum distributions (RMDs). RMD is not required for Roth IRA when you are 72 and up in 2021. 

7. Estate advantage: IRAs offer more payout options to beneficiaries. In contrast, 401k (s) usually will be paid out lump sum to beneficiaries which increases your tax rate. 

Disadvantages of IRAs

1. Do not have matching contributions:  Unlike 401K(s), IRAs do not have match-up contributions. Your retirement account is whatever you contribute.  

2. Income eligibility limit: Roth IRA has income eligibility restrictions. In 2021, singles must have Modified adjusted gross income (MAGI) less than $140,000. The contribution is phased out starting with MAGI of $125,000. In addition, married couples must have MAGI less than $208,000 and the contribution is phased out starting with MAGI of $198,000.

In contrast, 401k(s) or traditional IRAs do not have income eligibility restrictions. Whether your contribution will be the fully tax deductible depends on your income ( and your spouse’s income if you married)

3. Low contribution limit: In 2021, contribution is limited to $6,000 if age under 50; $7,000 if age 50 or above.

4. Loan: You cannot loan from your IRAs accounts. However, you can withdraw up to $10,000 for a qualified first time home owner. 

5. You choose to make investments yourself. So, It may be a disadvantage for some who do not feel comfortable to make their own investment choices. However, you can always choose to invest in less risk choices such as S&P 500.

401k(s) vs IRAs – Questions and Answers

1. Which retirement accounts can you take tax benefits when you contribute?

Traditional 401k and traditional IRA – you can take tax benefits when you contribute. Both help to lower your tax rate at the current tax year of contribution.  However, you pay tax later for distribution. 

2. Which retirement accounts are tax free for distribution?

Roth 401k and Roth IRA are tax free for distribution. However, you cannot tax benefits when you contribute because these contributions are post-tax contributions.

3. Which retirement accounts do offer variable investment choices?

You can have variable investment choices when you have Roth IRA and Traditional IRA accounts. You open your retirement account, make your own contribution and choose your own investments. 

4. Can you have both 401k and IRAs?

Yes, you can have both 401k and IRAs. When you leave a job, you can choose to rollover your 401k account from the former employer to your IRAs.

5. Can you take a loan from your 401k?

Yes, you can take a loan from your 401k. In 2021, you are legally allowed to loan your 401k (s) up to $50,000 or 50% of the total contribution, whichever is lesser. However, you have to pay back within 5 years to avoid tax and 10% penalty if you are under 59 ½ . 

6. Can you take a loan from your IRA?

No, you cannot loan from your IRAs accounts. However, you can withdraw up to $10,000 for a qualified first time home owner in 2021.