Retirement planning has changed dramatically over the years.
Gone are the days when most people had pensions.
Pensions would provide us with a monthly check for life until the day we died.
Now, unless you work under the government or a union, most of us no longer have that benefit.
The responsibility has shifted onto each of us to save for our own future.
When it comes to saving for retirement, most of us have 2 main options:
- A 401(k) – which is an employer-sponsored plan at your job
- An IRA – an individual retirement account
Oftentimes I’m asked which is the better option?
As always with personal finance, the right decision depends on your specific circumstances.
As a starting point, you should be aware of the differences between these accounts:
- Contribution limits
A 401(k) plan generally allows you to contribute more of your money into than an IRA.
As of 2024, a 401k allows you to contribute up to $23,000 annually. Or $30,500 if you’re above age 50.
While an IRA allow you to contribute up to $7,000 annually. Or $8,000 if you’re above age 50
- Matching or profit-sharing contribution
Since your 401k is held at your employer, oftentimes your employer will offer a “matching” or “profit-sharing” contribution where they also deposit money into your account as a benefit to you. This is an extremely valuable benefit that you should always consider taking full advantage of if your employer offers this.
Since IRA’s are not held at your employer, they do not receive this benefit.
- Investment flexibility
Since 401(k)’s adhere to stricter guidance under the ERISA laws, they typically offer less flexibility than does an IRA. Most of the time in a 401k you will see a range of 15-30 investment options that you are allowed to choose.
On the other hand, IRAs usually allow you to invest in hundreds of different investment options inside of your account, depending on which bank/brokerage you open your account with.
- Income limits
As of 2024, a 401k currently has no income limits. No matter how much income you make, you still have the ability to contribute to a 401k.
When it comes to IRAs, there are income restrictions set by the IRS. For example, if you are single and your modified adjusted gross income (MAGI) is $77,000 or less in 2024, your IRA contributions are fully tax deductible. If your MAGI is between $77,000 and $87,000 you receive a partial deduction and, if over $87,000, you do not receive a deduction for your contributions.
For Roth IRAs, your eligibility to contribute is based on your MAGI. As of 2024, if you are single and your MAGI is above $146,000, you can no longer make the maximum contribution to a Roth IRA. It is crucial to keep track of your income and make sure you’re still eligible if you choose an IRA.
- Taxes
An important consideration for your retirement account is whether you choose a “traditional” or “Roth” retirement account.
The main difference is how you’ll be taxed on the money you put into these accounts.
“Traditional” or “pre-tax” means that the money that you contribute into your account will not be included in your income when you file your taxes. This gives you a tax deduction in the year that you contribute. However, the downside is that when you withdraw your money in the future, you will pay ordinary income taxes on all the funds that you take out of your account. If you take money out before you reach age 59 ½, a tax penalty may also apply.
“Roth” works the opposite way. When we contribute to Roth accounts, the money we put in our account is after taxes have already been deducted. But if we follow the rules, all of the money we withdraw from our accounts in the future will be tax-free. But, if you take money out before age 59 ½ and having owned the account for 5 years, the earnings portion of your withdrawal will be subject to ordinary income tax and may also be subject to a tax penalty.
401ks, typically offer both a “traditional” and “Roth” option. But you need to check with your employer first to make sure this is the case.
IRAs can be opened as either a traditional or Roth, whichever you decide makes the most sense.
- Creditor protection
Since 401ks (and other employer-based retirement plans) fall under ERISA guidelines, they are federally protected from creditors in the event of a lawsuit. This means that any institution to whom you owe money, cannot make a claim against the funds held in your 401k. These funds, however, may be tapped if you owe money to the IRS or are engaged in a dispute involving child support, alimony, or dividing assets during a divorce.
IRAs, on the other hand, do not fall under ERISA guidelines and typically do not have such creditor protection. However, this varies by state, and it is important to check with your attorney.
If you are concerned about creditor protection, this aspect would favor 401ks.
- Loans
401ks, depending on the specific plan, usually offer you the ability to take loans from your account. Typically, this is limited to 50% of your account value, up to a maximum of $50,000 (IRS.gov).
IRAs, on the other hand, offer no such loan provision.
- Ability to utilize a ”Backdoor” Roth IRA
A “Backdoor” Roth IRA is a term used to describe a strategy where you make non-deductible contributions to a traditional IRA or 401k and then convert to a Roth. There are two ways to contribute to a Roth IRA using this “backdoor” method. In some instances, there may be a required holding period before you can convert to a Roth. Also, you will need to check with your employer to see if this option is available for your 401k plan.
This strategy can be helpful for those that earn too much to contribute directly to a Roth IRA.
As you can see, there are a number of considerations when determining the right retirement plan for you. Make sure you do your due diligence and work with a professional to ensure you’re picking the right one based on your personal needs and goals
None of this is meant to be financial advice, but purely for educational reasons only.
