Grandpa was an ox. Even well into his seventies he still had broad shoulders, a strong grip, and a brisk walk. For decades he tended railroads and farms to make a living. It wasn’t until his health declined that he was forced to retire. Growing up, we never understood why Grandpa worked as hard and as long as he did. It wasn’t until adulthood that we learned about pensions and retirement plans, which weren’t offered by my grandfather’s employer at that time. With a disabled wife and children still in college, Social Security checks weren’t enough retirement income. Grandpa didn’t work because he wanted to; he worked because he had to.
Luckily, today’s options for retirement have multiplied since then. While pensions are steadily disappearing from employee benefits, many companies now offer 401ks and IRAs in their place. These retirement plans, along with Social Security benefits, work together to provide a steady income for people to live comfortably after retiring. As you read on, we’ll compare the two, breaking down their differences and benefits to help identify which plan works best for you.
What Is a 401k?
A 401k is an employer-sponsored retirement investment account that is automatically funded through the employee’s payroll deductions. The plan is completely optional and can serve as an important addition to social security benefits. A 401k has no eligibility restrictions, such as a maximum level of income, and you can easily sign up for the plan through your employer’s human resources department. Beginning in 2019, employees can contribute up to $19,000 into their 401k accounts per year. By law, you can begin to withdraw from your account at age 59 ½ and must begin to receive distributions from your 401k savings no later than age 70 ½.
Types of 401ks
There are two types of 401k plans: a Traditional 401k and a Roth 401k. With the Traditional, your contributions and investment earnings are tax-deferred. Instead, you will be subject to paying taxes on those contributions and earnings once you withdraw the money during retirement. With a Roth 401K, on the other hand, you pay taxes on the money you put in now, but the income earned on the account, such as from interest, will be completely tax-free during retirement.
Benefits of 401ks
Many employers offer to match your contribution dollar-for-dollar, generally up to 3% of your salary. This means that you have the opportunity to receive FREE money from your company to go into your retirement. Keep in mind that the only way to maximize your earnings is to contribute the amount your company will match, so it’s wise to take full advantage. Also, you are able to write off your traditional 401k contributions as tax deductions.
Drawbacks of 401ks
A 401k is definitely a great way to ensure financial security in your retirement, but depending on your needs and expectations, there can be some downsides to them as well. With a 401k, employees don’t decide which brokerage, financial services company, or bank will manage their money. It's possible that your 401k could be placed with an investment firm that offers an extremely limited menu of investment options. In fact, some 401k plans are limited to just one stock or fund and don't give employees any choice at all. Others give employees a limited range of options, while still others give employees access to all of the investment vehicles that the brokerage offers. In evaluating whether a 401k is right for you, it's important to find out what your investment options will be. A percentage of your investments each year go toward fund fees, which are set by the financial institution chosen by your employer. Also, there is a 10% early withdrawal penalty if you decide to take out money from the account before age 59 ½. You will have to pay that penalty as well as taxes on your withdrawal.
Ownership/Vesting of 401ks
If in any case you decide to leave your job or get laid off, it’s important to learn your company’s vesting policy. “Vesting” refers to your ownership of the funds within your retirement plan. Any money you contribute is 100% yours, but the employer-match funds may not be fully yours until after a certain time period. Some employers may require you to work for their company for a few years before you have complete ownership of both your and your employer’s contributions.
For example, say you’ve only worked for your current employer for three years before leaving the company, but its 401k policy vests only 20% of employer contributions each year until you’ve worked for the firm for five years. When you leave, your 401k will consist of all of your contributions during those past three years, but only 60% of the contributions from your employer. You can learn about your employer’s vesting policy through its human resources department.
When leaving a company, many people perform a 401k “rollover,” which is when you direct the funds from your retirement account under your current employer to a separate, new plan outside of that employer. This is where an IRA comes in.
What is an IRA?
An IRA is an Individual Retirement Account that enables you to make investments and tax-deductible contributions into an investment account designated for retirement. Anyone can open an IRA on their own through a mutual fund company, brokerage, or local bank. IRAs are a great option for individuals who are self-employed, independent contractors, or whose employers don’t offer a 401k retirement plan. Individuals can contribute up to $5,500 of earned income each year, not including investment earnings. Just as with a 401k, you can start receiving distributions from your IRA account at the age of 59 ½, are subject to an early withdrawal fee of 10%, and must receive distributions no later than age 70 ½.
Types of IRAs
As with the 401k, there are two types of IRAs: the Traditional IRA and a Roth IRA. The distinction between the two is the same as it is with the 401k. With a Traditional IRA, your contributions are tax-deductible and you pay taxes on the funds once withdrawn from the account. With a Roth IRA, your contributions aren’t tax deductible but the withdrawals during retirement are completely tax-free. Some companies with 100 employees or fewer offer a SIMPLE IRA (Savings Incentive Match PLan for Employees), which is a type of Traditional IRA that has an employer-matching plan similar to a 401k.
Benefits of IRAs
As with a 401k, IRAs provide tax-advantaged retirement savings. The difference is that IRAs give you complete control over your account, meaning you decide which financial institution to use to manage your retirement account. Your contributions can be invested in stocks, bonds, mutual funds, CDs, and more. Also, if you already have a 401k with your employer, you can still open an IRA as an additional retirement option to fall back on.
Drawbacks of IRAs
Once again, depending on your needs, there are a few downsides to having an IRA. The contribution limits are much lower than that of a 401k, but it balances out considering your diverse investment options. Also, if your IRA funds aren’t withdrawn before age 70 ½, you could face a 50% penalty. This may not be much of a concern for those who expect to be retired long before then, but for individuals who may still be working at that age, it could be a disadvantage.
Comparing 401ks and IRAs should be done with an eye toward your individual needs and circumstances. When considering your age, career, family necessities, and financial plans, one option may seem like a better fit than the other. Both retirement plans have the 10% early withdrawal penalty, but also offer early withdrawal penalty exemptions for those who want to buy their first home, need to pay off medical expenses, or have become permanently disabled before age 59 ½. Many financial experts recommend having both plans, where each can fill in the gap for certain needs. Whichever you choose, rest assured you will enjoy a financially secured retirement.