To enjoy retirement to the fullest, one has to have prepared adequately for it during the days when they were still fully employed. There are many different ways to save for retirement, but in the US, most employees choose to invest in either a 401(k), traditional IRA, or Roth IRA.
Considering the enormous importance of making the right investment option, it is surprising how many employees regularly make this decision without knowing much about either of these account portfolios.
While they have all proven to be solid investment options for a retirement account over the years, there are definite differences between Roth IRA and 401(k) that need to be considered by any serious investor.
This article will look at the specifics of traditional IRA, Roth IRA, and 401(k) retirement accounts, among other popular choices, to help employees choose the right plan to suit their needs.
We will dig deep into the details regarding contribution limits, tax deductions, tax advantages, employer contributions, and employee contributions. By the end of the article, readers will be armed with all the information needed to make informed decisions.
Table of Contents
What You Need To Know About a 401(K) And an IRA
401(k), Roth IRA, and Traditional IRA accounts are the most common means to save for retirement. They all come with various tax benefits that make them attractive choices for employees.
Employers offer their workers different choices based on how much they can afford to contribute and the size and structure of the company. Individuals can also decide to handle their retirement accounts on their own, without involving employer contributions.
In most cases, employees contribute to a 401(k) by deducting a percentage of their salary and the employer may choose to offer a matching contribution.
If a 401(k) is not the desired option, then employers may offer a Savings Incentive Match Plan For Employees (SIMPLE) IRA, or a Simplified Employee Pension (SEP) IRA, although these options are usually preferred by small businesses with few employees.
Individuals can choose to open both a 401(k) and Roth IRA account, but the IRA will come without the benefit of employer contributions. Specific contribution limits, income limits, and tax benefits apply to each IRA, which is something employees have to be careful of if they choose that route.
The advantage of either option is that both Roth IRA and 401(k), offer a tax break for all funds deposited into the accounts.
This means, apart from account fees and various other costs associated with maintaining their retirement accounts, employees only need to worry about being taxed on their after-tax dollars, which is the taxable income after all deductions have been made.
Any money deposited into either a 401(k), Roth IRA, or Traditional IRA is considered a long-term investment that is not eligible for tax-free withdrawals before the employee turns 59 and 1/2 years old. If they withdraw money before that time, they will be charged tax penalties by the IRS.
How Does Taxable Income Fit In?
Distributions, or withdrawals, from a 401(k), traditional IRA, or Roth IRA are considered taxable income, meaning individuals will be expected to pay taxes on that money.
The tax rules are different for all retirement accounts, with Roth IRAs offering tax-free withdrawals after retirement. A typical 401(k), on the other hand, will allow pre-tax income to be deposited into the account, which will reduce the total taxable income for that year.
Will You Pay Taxes on Funds in a 401(K) or IRA Account?
One good thing about having either traditional IRAs, 401(k)s, or Roth IRAs is that they come with a lot of tax advantages. The only time an individual retirement account will be taxed is when the owner chooses to withdraw money before the right time, in which case the tax benefits will seize to apply.
Even then, then there are ways to avoid taxes, such as by doing an IRA rollover into a Roth IRA, which does not charge taxes on withdrawals done at the right age, and after the required five years have elapsed.
Early Withdrawal Penalty
According to the IRS, if employees withdraw funds from a Roth IRA, or 401(k) early, they must pay taxes of up to 10% of the value of the distributions. In this case, distributions are regarded as any withdrawal before the age of 59 and 1/2 years old.
However, a Roth IRA offers account holders a way around these withdrawal rules by allowing tax-free withdrawals for funds that have been held for five years or more. This is because, unlike other retirement account options, Roth IRAs have no required minimum distributions.
Costs Associated With 401(K) and IRA Accounts
While retirement accounts can be thought of as tax-free money because taxes will only be charged on after-tax dollars, 401(k) and traditional IRA account fees need to be considered when selecting the better option. In that regard, the following account charges apply:
401(K) Account Fees
Typical 401(k) retirement account costs usually range between 0.5% and 2% of the employer-sponsored retirement plan, based on the following factors:
- Size of the retirement savings account
- Number of people on the plan
- The workplace retirement account provider
Many retirement plan providers also charge annual fees which are usually less than 1% of the employer-sponsored plan.
IRA Account Fees
Most Roth IRAs, and traditional IRA accounts, do not charge any setup fees. However, they do charge an annual contribution towards the maintenance of the account, which in most cases is between $30 and $50. This fee is sometimes called a custodial fee and includes any transaction and advisory fees that may be applicable.
The Basics of a 401(k)
A 401(k) can be defined as a tax-deferred retirement savings account that is offered to individuals by their employers.
The most common way of funding this retirement plan is by withholding a certain percentage of money from the employee’s salary and having the employer match the value of the contribution up to a certain limit.
Employee Contributions
In most cases, the amount of money an employee chooses to contribute towards their 401(k) is removed from their total salary before any tax deduction, which means only the after-tax dollars will be taxed.
The IRS sets contribution limits to the amount that an employee can put into their 401(k) account, with certain considerations made for individuals aged 50 and older.
In 2021 and 2022 these contribution limits were $19,500 and $20,500 respectively. The so-called catch-up contribution for individuals 50 and older raised the contribution limits to $27,000 in 2022.
Employer Contributions
Employees may be lucky enough to have an employer match their 401(k) contributions, but that is not always the case. There are many reasons why employer contributions may not be offered, and one of these is determined by whether the employee contributions meet the minimum requirement of 6% of their salary or not.
When an employee contributes at least 6%
In most cases, if the employee contributions are at least 6% of their salary, then the employer matches them up to 50% of the contribution. This means, for example, if 6% of the employee’s salary is $10,000, they can have their employer match by contributing $5,000.
However, suppose the employee’s contributions are more than 6% of their salary. In that case, their employer will not add any more money on top of the 50% they are already contributing.
When an employee contributes less than 6%
In cases where the employee contribution towards their 401(k) is less than 6%, they will not be entitled to have their employer match their contribution, and may end up receiving a reduced employer contribution, or sometimes nothing at all.
IRS Rules Regarding Employer Contributions
To safeguard both the employer and employee, the IRS put in place rules governing employer contributions, provided that the salary meets the prescribed income limits.
Annual contribution limits from employees were set at $61,000 for 2022, with this amount increasing to $67,500, including catch-up contributions, for individuals aged 50 and older.
How Distributions From 401(K)S Work
According to the withdrawal rules for a 401(k) individual retirement account, no penalties will be charged on any distributions made after the account holder turns 59 and 1/2. However, these withdrawals are not tax-free; therefore, the individual will be taxed according to the rate of their income taxes.
Pros and Cons of Choosing a 401(K)
Employees who are leaning towards this type of investment should consider the following facts:
Pros
- A 401(k) has higher contribution limits
- Employees can take loans from their 401(k) funds
- When an employer matches the employee contributions, the value of the 401(k) can increase significantly
Cons
- There are fewer investment options for funds held in a 401(k) account
- Compared to, for example, a Roth IRA plan, 401(k) accounts have higher fees
Individual Retirement Accounts (IRAs) Explained
Employees have a lot more flexibility when it comes to selecting an individual retirement account because unlike a 401(k) there are different types of IRAs to choose from, such as a Roth IRA, Traditional IRA, and many others.
An IRA can be managed by the employee themselves, without the contribution of their Employer. However, they do require a custodian to be placed in charge of the safekeeping of the account, and this can be a bank, investment firm, credit union, or a brokerage house.
Depending on the choice of the custodian, an IRA account holder has the option to invest in any of the following:
- Stocks
- Bonds
- Mutual funds
- Certificate of Deposit (CD)
- Real estate
- Precious metals
Pros and Cons of Investing in an IRA Retirement Account
The diversity of options offered by IRAs, such as when investing in traditional and Roth IRAs, also serves to increase the risks associated with them. While for the most part Roth IRA contributions and other types of IRA are solid retirement savings options, it is worth it to keep in mind the following:
Pros
- Wide range of investment options
- Can hedge against inflation, for example, in the case of a precious metals IRA
- The account holder has greater control over the costs
Cons
- Individuals cannot take out loans against an IRA
- Generally, there are no employer contributions
- Lower contribution limits compared to a 401(k)
The Common Types of IRAs
As we have already mentioned, there are many types of IRA accounts to choose from, depending on the needs of the individual, the budget, and any assets the employee already owns that can be included in their IRA account.
The following are the most commonly used IRAs:
Traditional IRA
In a traditional IRA, individuals contribute funds, before any tax deduction, towards a retirement savings account, where they can grow until withdrawal. In some ways similar to a 401(k), a traditional IRA is regarded as being based on a tax-deferred investment growth system.
Taxes will only be charged when the individual makes a withdrawal, upon retirement, and will be set according to their current income tax deduction rate.
Roth IRA
As far as getting a tax break is concerned, Roth IRA contributions are the way to go. A Roth IRA is a tax-free growth individual retirement plan that also allows individuals to make withdrawals without paying taxes in retirement.
The major requirement of these retirement plans, is that funds have to be kept untouched in the Roth IRA account for at least five years and that the age of the account holder is 59 and 1/2 years or more before any tax benefit can be applied.
Sep IRA
In the same way as 401(k) retirement savings accounts, employer contributions can be added to traditional IRA contributions, which would make it a Simplified Employee Pension Plan. Employers can contribute as much as 25% towards their employee’s SEP IRA.
This type of retirement planning is usually utilized by a small business with a workforce of less than 100 or by an employee whose income limit does not make having a regular 401(k) feasible.
The key difference between a SEP IRA vs. 401(k) is the contribution limits, which are much lower for SEP IRAs.
Simple IRA
A Savings Incentive Match Plan For Employees (SIMPLE) IRA, differs from a SEP IRA in that it allows an employer to pledge a matching contribution of up to 3% of the employee contributions. The other option available to employers in this type of retirement savings account is to offer a 2% contribution of each employee’s salary.
Best Type Of IRA for Young Investors
Young investors looking for a suitable long-term investment plan are better suited to investing in a Roth IRA. While going for traditional IRA contributions will mean that the funds are tax-deductible, it is with a Roth IRA that any distribution is tax-free after five years, which should not be a problem for people still in the early stages of their career.
Main differences between an IRA vs. 401(K)
The main idea behind a typical IRA, such as a Roth IRA, and a 401(k) retirement savings plan is the same, which is to provide a feasible way to save for retirement while enjoying better tax deduction.
Where these two differ is that, while individuals can set up and control their own Roth IRA, a 401(k) requires that an employer match the contribution of the employee.
The nature of the tax benefits is also different, for example, while a Roth IRA can grow tax-free in retirement, a 401(k) is tax-deferred until the time when withdrawals are made.
IRA vs. 401(k) plans. Which Is Better?
It is not easy to pick which option is the better of the two accounts without looking at the specific needs of the individual, and the nature of their employment.
A 401(k) is the better choice in terms of having significant employer contributions which allows the account to grow much faster than a self-funded IRA. While it has a limited investment selection, it offers a larger catch-up contribution limit for employees over the age of 50 years old.
However, a Roth IRA does grow tax-free and is certainly the better option for younger investors and self-employed individuals who do not have taxable income, an employer to contribute to their retirement savings.
Both options are good, as long as careful consideration is made regarding individual circumstances and the kind of tax advantage that is required.
How Secure Is Money Invested in an IRA vs. 401(K) Account?
In terms of the safety of funds, a 401(k) offers the best security from creditors, bankruptcy, lawsuits, and the like. However, if the right custodian is selected for an IRA Roth account, then it can be quite secure as well, with both options providing adequate insurance cover against any losses.
A good choice in IRA provider, for example, choosing a real estate or precious metals IRA, can be a much better option than a 401(k) in terms of hedging against inflation. This is because while funds in a 401(k) are very much at risk to global economic trends, an IRA based on, let’s say, gold, will prove to be highly resistant to such changes.
Using a 401(K) for an IRA Rollover
One of the most popular ways of funding an IRA is by doing a rollover of funds from an existing 401K account. This is the type of investment advice usually given by IRA custodians because it is usually the fastest way to get the funds approved by the IRS and have the account up and running.
Another reason why people would consider doing an IRA rollover is as a means to avoid having to stick to the 401(k) rules regarding required minimum distributions. This move also has the advantage of turning tax-deferred funds into tax-free money.
Avoiding IRA Penalties During a Rollover
There are strict IRS rules and regulations regarding how IRA rollovers are conducted, and failure to meet these conditions will result in penalties being charged.
Before one can enjoy the better investment gains on after-tax money that come with conducting an IRA rollover, they must ensure that the funds taken from their 401(k) do not sit in their account for more than 60 days.
A penalty-free rollover can easily be achieved with the right custodian handling the account, because the entire process is quick, and takes a lot less than 60 days for the IRS to verify funds that are taken from an active 401(k).
Key Points to consider when choosing between an IRA vs. 401(k)
When it comes down to making a decision between these options, it is important to pay particular attention to the following key points:
Employer Match
If the employer offers to match the employee contributions then an employer-sponsored retirement plan such as a 401(k), or at the very least a SEP IRA is the way to go.
However, if such employer matching contributions are unavailable, then it is better to consider a better option, such as opening a Roth IRA account.
Age
Younger investors have a lot to gain from investing in a well-managed Roth IRA than any other retirement plan unless their employers offer very good contributions that will make a 401(k) look like the better option.
If both an IRA and 401(k) look like good options, there is always the choice of choosing to invest in both, which would bring a lot more tax benefits.
Self Employed
Individuals who are in business for themselves are better suited to investing in a Roth IRA. Without the benefit of having an employer match their contribution, there is no need to opt for a tax-deferred retirement plan over one without taxes.
Final Word
Good retirement planning is very important to fully benefit from the years of hard work that an employee would have put in.
With the many options that are available, taking the time to read this article, and make a well-informed decision, will help in picking the best retirement savings plan that offers better tax treatment for employees.
Both the 401(k) and IRA retirement plans are great ways to gain an immediate tax benefit and save for life after retirement, without which, individuals risk losing their hard-earned funds through other less-regulated investments.
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About Tim Schmidt
Tim Schmidt is an Entrepreneur who has covered retirement investing since 2012. He started this website to share his expertise in using his Self-Directed IRA. Most recently he's been advising individuals to diversify into precious metals ahead of a certain recession. He invested with Goldco.