What Is the Difference Between an IRA and a 401k? (And When Should I Use Each)

By June 1, 2019 Blog No Comments

It’s never too soon to start planning for retirement.  All financial advisors agree that the earlier you start to save for your retirement, the better off you’ll be when you reach retirement age.  So how is your retirement savings? Did you wake up one day and realize that you don’t have anything in place besides Social Security?

Don’t worry, for most people if you’re still working there’s still time to build up some supplemental retirement money that you can use when you retire.  The two most common retirement savings options are an individual retirement account, or IRA, and 401k plans. To decide which option is best for you, it is important that you know the differences between the two. Let’s cover the basics for each plan, and also a third option, the Roth IRA:

401k Accounts

In order to start a 401k account, you must work for an employer that provides one, usually as part of a benefits package.  If your employer doesn’t offer a 401k plan, then this isn’t an option for you. Contributions to a 401k plan are made as pretax payroll deductions on the paycheck, which reduces your taxable income for each pay period.  Some employers will help you to grow your account by matching your contributions up to a predetermined amount. Employees with an employer that matches should take full advantage and contribute as much as they can afford.  The employer is giving you free money to put towards your retirement!

Investment options on a 401k account are usually limited to a number of mutual funds at various growth and risk levels determined by your employer’s plan provider.  You can choose to place your money in one or several of the mutual funds in order to experience gains or losses. Make sure to select mutual funds that are consistent with your personal risk level.  For example, if you prefer safety, place your funds in a mutual fund that is heavy in government bonds and safe securities. Some plans have brokerage options as well, which are available for additional fees and management expenses.  Your investment options are limited by your plan.

The maximum amount an individual can contribute to a 401k is $19,000 per year.  People over 50 years old can contribute $6,000 more. Maximum contribution amounts are increased periodically to keep pace with inflation levels, so keep track of the maximum allowed and try to contribute that amount if you can.  Remember that the more money you contribute every year, the faster your account will grow.

According to the IRS, you may start to withdraw money from your 401k account at age 59 ½.  However, if you are still working your employer may not allow you to do so. You are required to receive distributions from your 401k every year after you reach age 70 ½, whether you want to or not.  All money received from your 401k plan is taxable income, since the contributions to the account were made pre-tax. This is a major difference between 401k plans and Roth IRAs.

There are no income limitations when it comes to 401k plans.  The only limitation is the amount you are allowed to contribute, up to $18,000 per year.  This makes 401k plans available to all employees, regardless of how much or how little they make each year.

IRA Accounts

To open an IRA account, you must be under the age of 70 ½ and earning an income.  IRAs are available at banks and other financial institutions and must be opened by you.  Your employer is not involved in any way with your IRA. All contributions to an IRA are made from the money left over after income taxes have been taken out of your paycheck.  Contributions to your IRA may be tax deductible based on your income.

Investment options with an IRA account are only limited to the investments that the financial institution offers.  This gives customers the freedom to invest their IRA money in securities, mutual funds, or bonds as they see fit. Before opening an IRA, make sure that the institution has the investment options you’re looking for.

IRAs have a maximum amount you can deposit into them each year.  The maximum is currently $6,000 per year, or $7,000 per year if you’re older than 50 years of age.  After reaching the age of 70 ½, you can no longer contribute to your IRA account.

You must begin withdrawing money from your IRA when you reach age 70 ½, but you can begin receiving money from the account as early as 59 ½.  All funds received from a traditional IRA account are subject to income taxes as taxable income.

There are no income limits when establishing a traditional IRA account.  Whether you file taxes jointly, single, or head of household, you can have an IRA no matter how much money you make.  This makes traditional IRAs the best choice for high-income individuals who don’t have the option of a 401k at their current employer.

Roth IRA Accounts

Roth IRAs are available from banks and other financial institutions to people under 70 ½ years old.  A Roth IRA is funded from after tax earnings, and is not tax deductible. Most banks have Roth IRAs available for their customers who don’t have a 401k at work or a traditional IRA account.

Your Roth IRA funds can be invested in any stocks, bonds, or mutual funds that your financial institution has available.  The freedom to invest your money as you see fit makes Roth IRAs an attractive option for many people when considering a supplemental retirement account.  Make sure your new Roth IRA has the investment options you want before you open your account.

The maximum amount you can deposit into your Roth IRA is the same as a traditional IRA.  The limit is $7,000 for those over 50 years old, and $6,000 for those under 50. You can continue to make contributions to your Roth IRA after you begin receiving payments at the age of 70 ½, which makes Roth IRAs a good choice for people who continue working after retirement age.

You may begin to receive payments from your Roth IRA account when you reach the age of 59 ½, but you absolutely have to after you reach 70 ½ years of age.  All funds withdrawn from your Roth IRA are not subject to income tax, since the money contributed is from after tax earnings, and contributions were not previously used as a tax deduction.  This is a major difference that makes Roth IRAs an attractive option for many retirees.

There are income limits when it comes to Roth IRAs.  People who are married and file taxes jointly cannot make more than $193,000 combined annually to qualify for a Roth IRA account.  Single or head of household taxpayers must make less than $122,000 per year in order to qualify. Make sure your income does not exceed these numbers before attempting to open a Roth IRA to avoid any possible tax implications.

Who should use a 401k?

Anyone who has access to a 401k program at work should use it.  This is especially true for those of us who have put off planning our retirement.  The 401k allows you to put the most money into it per year, which allows your account to grow rapidly.  If your employer matches a portion of your contributions, it is even more important to capitalize on the “free money” they are providing for your future security.  This is an important benefit that many companies are pleased to offer their employees as part of an attractive compensation package.

Who should use a Traditional IRA?

Traditional IRAs are the best option for high-income individuals without access to a 401k plan.  There are no income requirements for IRAs, so big earners can have one. Since the maximum contribution amount is much lower than the max on a 401k, opening an IRA early makes it a much more effective retirement tool.  People who want the freedom to invest their funds in a wide variety of financial products can use their market knowledge to maximize the growth of their IRA.

Who should use a Roth IRA?

Roth IRAs are the best option for single-income and lower-income households without access to 401ks.  These households tend to have less money saved when they reach retirement age, so the added benefit of the money being non-taxable is critical to their financial well being.

Final Thoughts

If you’re starting to think about retirement, the time to start is now.  401ks, IRAs, and Roth IRAs are all good options when saving for retirement income.  If your company offers a 401k, you should definitely use it. If you don’t have that option, consider opening an IRA that fits your current situation, and try to save the maximum amount each year.  Remember that payments from 401ks and IRAs are taxable, while those received from Roth IRAs are not. Congress continues to borrow from Social Security, so by the time you retire, it may not be available to you.  Take steps to ensure your financial future and open a supplemental retirement account today!

About Woven Capital

Aaron Hatch is a Certified Financial Planner and co-founder of Woven Capital, a fee-only financial planning and investment management firm that specializes in helping people balance life, work, and community. Aaron has been quoted in various publications, including The Chicago Tribune, US News and World Report, and the Huffington Post among others. Aaron can be reached at aaron@wovencapital.net