401(k) vs. IRA: Which is better?

Summary:

  • 401k has higher allowances for tax-deferred savings
  • Your employer may provide "matching" contributions to your 401k plan
  • You can borrow money from a 401k but not from an IRA
  • Typically more investment choices with an IRA
  • Each has eligibility requirements

Unless you're already independently wealthy, you should no doubt be concerned with the financing of your future retirement years. Prudence suggests that you should be investing in a 401(k) plan if your employer offers it, or you should be putting money away in an Individual Retirement Account (IRA). You certainly should not be trusting only Social Security to fund your latter years. Given the choice, 401(k)s do seem to have a number of advantages over traditional IRAs.

401k Advantages

Although both programs have government-mandated limits on the amounts of pre-tax dollars that can be placed in them per year, the maximum for the 401(k) is considerably higher. For 2011, you can put up to $16,500 into a traditional or safe harbor 401(k), and up to $11,500 into a simple 401(k). By comparison, IRA contribution limits are only $5,000 for 2011.

However, this does not take into account any employer-imposed contribution limits. For instance, if your yearly salary is $50,000 and your employer limits your 401(k) contribution to 10 percent of that salary, then your maximum allowable contribution would be $5,000.

Many employers make matching contributions to their employee's 401(k) accounts, typically as much as 50 cents on the dollar for up to 6 percent of the employee's salary. Some are even more generous. That amounts to free money being deposited and compounding in your retirement fund. It doesn't get much better than free cash.

Another advantage is that you can generally borrow money from your 401(k) without penalty (as long as you pay it back, of course). You can't borrow from an IRA.

Under certain circumstances, you can withdraw money from your 401(k) before you reach age 59½; for instance, if you need it to pay medical bills. To qualify, the expenses would have to be tax-deductible; in other words, they must exceed 7.5 percent of your adjusted gross income. You can also make early withdrawals of 401(k) funds if you become disabled.

Additionally, some mutual funds that normally charge a load (or, sales fee) may forego the charge when you invest through a 401(k) plan.

Many people incorrectly think that there are major differences between the deductibility of a 401(k) plan and an IRA. With a 401(k) plan, the money is automatically taken out of your paycheck and put your retirement plan, thereby reducing the taxable income that's reported on your W-2. With an IRA, you declare the amount of the contribution on your Form 1040 and the corresponding amount is subtracted from your taxable income. There's no real difference.

IRA Advantages

However, traditional IRAs have some advantages, as well. Currently, you probably have a far wider variety of investment choices with IRAs than with a 401(k). Many 401(k) plans allow for very limited choices.

Also, with IRAs you can open and close positions in different investments quite readily. With a 401(k) plan, your ability to switch your investments may be limited; for example, some plans may only let you make changes once every three months or so.

Make sure that your retirement plan meets your needs and provides a good opportunity for you to reach your goals. If you haven't undertaken a retirement plan as of yet, the clock is ticking. Every day that you're not working toward your future nest egg will make it that much more difficult to build a solid financial future for your golden years. Take advantage of the opportunities that are available to you.

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