Individual retirement account (IRA) and 401(k) are both great plans available in the U.S. for retirement savings. Both the plans are quite similar and come with tax-advantaged features. Therefore, it naturally gets confusing for people to choose between the two.
Many financial advisors you consult would recommend you opt for both IRA and 401(k) plans. But many people cannot afford to do. So how do you decide between IRA and 401(k)? Which one is right for you? Let’s find out!
How Does IRA Work?
An IRA is a tax-advantaged plan that is set up through banks and brokerages. In terms of investments, an IRA offers many options for you to choose from. An IRA also allows you to avail an IRA contribution deduction if you stay within the income limits and follow all the rules.
Roth IRAs
The Roth IRAs are very similar to a traditional IRA in that they also have contribution limits and early withdrawal options. The main difference between the Roth IRAs and the traditional IRAs is that the contributions you make in Roth IRAs are not tax deductible. Therefore, you won’t be required to pay taxes on any money you withdraw in the future because you’d have already paid the taxes while making the contributions.
Another key difference between Roth IRAs and traditional IRAs is that Roth IRAs don’t have minimum distribution requirement. For instance, for single files opting for Roth IRAs, they can contribute the full amount provided that their income is less than $125,000. For a married couple opting for Roth IRAs, the income limit is $198,000. People exceeding these limits are allowed to contribute reduced amounts.
Roth IRAs vs. Tradition IRAs: Which to Choose?
Since both traditional and Roth IRAs have a lot of similarities, the decision comes down to the filer. It depends on how you want to save on taxes, i.e., pay taxes while making the contributions or while withdrawing.
How Does 401(k) Work?
Unlike IRAs, 401(k) plans are offered by employers. For a 401(k) plan, employees are required to contribute a certain percentage of their pre-tax salaries. The taxes are to be paid when withdrawing funds. A 401(k) plan also features the employer match option. Your employer would either match a portion or 100% of your annual contributions.
So how long does it take to withdraw money from 401k? Well, you can withdraw your money from a
401(k) plan when one of the following occurs:
- You die, become disabled, or otherwise have a severance from employment.
- The plan terminates, and no successor defined contribution plan is established or maintained by the employer.
- You reach age 59 ½ OR experience a financial hardship.
Roth 401(k)
Since you contribute pre-tax salaries in traditional 401(k), Roth 401(k) requires you to contribute after-tax salaries to your 401(k) plan. You can then make tax-free withdrawals. Not many companies offer Roth 401(k) plans but they are getting popular.
If you have the option to choose between a traditional and Roth 401(k) plan, you may consider (with the help of a tax advisor) a Roth 401(k) plan as you can then avoid potential increased marginal tax rates in the future.
IRA or 401(k): Which One to Choose?
If you consult with a wealth management services provider, your financial advisor would likely suggest to include both 401(k) and IRA plans for your retirement savings to potentially get the better outcomes. But if you must choose one, an IRA offers more investment options whereas a 401(k) allows higher contributions. Therefore, it comes down to personal preference.
The content and opinions provided here are for general information only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 1⁄2 may result in a 10% IRS penalty tax in addition to current income tax.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 1⁄2 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.