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401(k) vs. IRA – Which is best?

5 Key Differences to consider

Planning for retirement can be an overwhelming task when first starting out, as many get stuck deciding what type of investment vehicle makes sense for them. In a perfect world, you will be in a place financially where you can take advantage of both an IRA and a 401(k), however if you have to select only one, remember these key differences.

401k vs IRA

Type of Account

The 401(k) plan is an employer sponsored account, meaning once you leave that company, you can no longer add additional funds to it. Oh, if you think you aren’t going to leave your current company, you are likely not being honest with yourself.  Job hopping is not viewed as taboo as it was ten to fifteen years ago, and a recent Gallup report shared 1 in 5 millennials have changed jobs within the past year. Does that mean you should not enroll in a 401(k) if you don’t see yourself with an employer long term? Absolutely not. Don’t put your financial future on hold. An IRA account is driven by you, the individual, and no matter where you are employed, you can contribute annually.

Contribution Limits

The 401(k) plan your employer provides does have an annual limit that you can contribute to, although many are unaware of this fact. For 2019, you can elect up to $19,000 of your income to go to your 401(k). In comparison, you can contribute up to $5,500 to an IRA plan this year. If you have not yet set up an IRA, it isn’t too late to get one established and contribute before we move into 2020.

Penalties

If you need to withdraw funds from your 401(k) plan, you will be faced with pretty steep penalities. If you are under the age of 59 ½ and take an early withdrawal, you will face a 10 percent penalty on your balance, as well as the monies being pulled out being subject to income tax. To make those numbers real, if you withdrew $5,000 from your 401(k) for Christmas gifts, and your gross income is $85,000 a year, you fall in the 24% tax bracket, which means your total in penalties and taxes would be nearly $1,700. We can’t stress enough that taking funds out of your retirement plan should be an absolute last resort due to stealing from your future as well as often putting a small band-aid on a likely large cut (the “financial emergency” you are facing).

If you need to withdraw funds from your IRA plan, the same penalty amounts apply if under 59 ½.

Income Limitations

With your company sponsored 401(k) plan, there are no income limits or restrictions on who can contribute. It is extremely important when starting a new job you know your benefits, the timeframe you can enroll in, and the company who is handling your retirement plan. If you were to work for Citigroup, one of the largest financial institutions in America, you would be pleased that they match 100% of their employee’s first 6% of contributions, along with an additional 2% added in at year-end.

Taxation of Contributions

Perhaps the biggest difference between the 401(k) and IRA plans fall around how you are taxed on each contribution. With a 401(k) plan, your employee contributions are made with pre-tax dollars, reducing your taxable income during each respective contribution year. Investment earnings are not taxed until withdrawn from the plan. With an IRA, it depends. If you elect to have a Roth IRA, there is no tax break up front, however your withdrawals are made tax-free, whereas the 401(k) will be taxed as ordinary income.

So which one is better?

If your employer offers a 401(k) program with a healthy match, it makes sense to sign up and claim those free dollars. A Roth IRA doesn’t have an option to offer that type of benefit. If you find yourself in a higher income tax bracket consistently, a Roth IRA may make the most sense for you. Having both an IRA and 401(k) presents the best strategy to secure your financial future. As always, for specific questions to your personal situation, we suggest speaking with a retirement planner.

Related: Personal Capital shares the average 401(k) balance by age. Are you on track?

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