Everyone seeking to retire wants a comfortable retirement. Whether you are approaching retirement or are in the midst of your career, you may have questions about which type of retirement vehicle is best for you. In this article, we’ll primarily discuss some important differences between traditional Individual Retirement Accounts (IRA) or a company-sponsored 401(k) plans. Both offer the opportunity to save money for retirement with the objective of making that money grow.
Is one type of vehicle better than the other? Not necessarily. Each offers important advantages that help you save for your retirement, so it’s helpful to know the differences between them. Though there are many other types of retirement plans and IRAs, such as tax-exempt Roth IRAs, we’ll focus on traditional pre-tax IRAs and 401(k) plans, as these are two of the most common retirement vehicles.
Traditional 401(k)s and IRAs let you contribute money to an account, and not pay any income tax on the earnings until you withdraw the funds. This generally makes it easier for people to invest money for a long period of time, which allows their savings to benefit from compound growth. Ideally, investors should try to maximize their contributions to both 401(k)s and IRAs. Employers can also contribute to an employee’s 401(k) using a company match.
One of the biggest differences between these two types of retirement savings accounts is how they are set up. A 401(k) is an employer-sponsered plan; a traditional IRA is a retirement savings account and is typically set up by an investor through a brokerage firm or bank.
Many investors use a company-sponsored 401(k) retirement plan as a basic retirement savings tool. This type of account is usually arranged by employers for their employees. Pretax contributions to a traditional 401(k) grow on a tax-deferred basis and, along with the 401(k)’s earnings, aren’t taxed until the money is withdrawn. While employees can usually direct where their money is invested, the employer generally controls the available investment options within the account. For example, many companies require employees to invest their money in their choice of company stock or a limited number of mutual funds that have been selected and approved by the company.
Unlike a 401(k), a traditional IRA is not sponsored by an employer. An individual (or an agent acting on the individual’s behalf) establishes the account, and then contributes after-tax dollars (which he or she may be able to deduct from taxes). Only the investor or designated agent can make decisions regarding the account. A traditional IRA may offer more flexibility than a 401(k), depending on the retirement plan’s restrictions. Anyone under the age of 70.5 with taxable income can contribute to a traditional IRA, and can choose to invest in individual stocks, bonds, mutual funds, exchange-traded funds and a wide range of other investments. An investor can choose to open a traditional IRA through a broker or firm that provides the best investment choices.
The contribution limits of 401(k)s are higher than those of an IRA, although these limits can change from time to time. For 2018, the annual contribution limit for 401(k)s is $18,500, and account holders who are 50 years of age or older can make additional “catch-up” contributions of up to $6000 per year
Many employers match an employee’s 401(k) contributions, which gives plan participants additional incentive to save. For example, an employer may choose to “match” employee contributions up to 3% of an employee’s salary, or at a higher or lower rate if they so elect. Typically, employer contributions are based on a specific percentage of an employee’s pay and are often subject to a vesting period. Employer matching helps the employee save more money and the power of compounding can help it grow faster, to provide more funds for use in retirement.
Contribution limits for IRAs are much lower. For the 2018 tax year, limits are $5,500 or $6,500 for account holders who are 50 or older.i
Both the traditional versions of 401(k) and IRA plans defer income taxes on contributions, but there are some differences in tax treatment. Contributions to a traditional 401(k) are pre-tax, meaning the contribution amount is paid from the employees’ earnings before income taxes are calculated and withheld.
Any money you contribute to traditional IRAs is from after-tax income where you may deduct your contributions from your taxes (subject to income limitations) and when you withdraw that money during your retirement, the contribution, along with the applicable earnings, will be taxed as income.
A Roth IRA is another type of retirement vehicle with a different tax treatment: your contributions aren’t tax deductible—they are taxed as regular income. However, when you are retired and you take a withdrawal from your Roth IRA, that money is not taxed as income, since you already paid income tax on the contributions in the year you contributed them to your account. Note that not everyone can contribute to a Roth IRA—there are contribution restrictions for people with higher income levels. For more information on the specific rules surrounding Roth IRAs, please visit www.irs.gov.
A growing number of employers are now offering a fourth retirement savings option called a Roth 401(k), which combines some features of both a Roth IRA and a traditional 401(k). The hybrid nature of this account can make taxes somewhat more complex. Contributions to a Roth 401(k) are made on an after-tax basis, which means in retirement, you won’t pay taxes on distributions. Any matching contributions made by your employer must still go into the traditional 401(k) account, and, along with the earnings, will be taxed when they are withdrawn. As with a traditional 401(k), your ability to open a Roth 401(k) is not subject to any income restrictions.
The primary objective of retirement accounts is to help people save money and invest for retirement, so retirement accounts often deter investors from taking withdrawals before retirement. However, if you need access to these funds before retirement, you may be able to obtain an exception to the 10% early withdrawal penalty depending on your circumstances. Generally, all retirement savings plans restrict withdrawals before age 59.5. However, Roth IRAs and Roth 401(k)s place additional restrictions on contributions made within the previous five years.
There is also the “rule of 55,” which may allow you to take withdrawals from a 401(k) at age 55 under certain circumstances.ii If you are at least 55 and you leave the company that sponsors your 401(k) plan, you may be able to avoid the 10% early withdrawal penalty. Employees of some organizations can start taking penalty-free withdrawals at the age of 50.
Except in limited cases, withdrawals made before age 59.5 are taxed as income and subject to the 10% penalty. Even a “hardship withdrawal” is usually subject to a 10% penalty from the IRS and also taxed as ordinary income. However, there are some exceptions for specific circumstances and purchases. Also, each type of retirement accounts generally allows you to take withdrawals without any penalty if you become disabled and can no longer work.iii Before taking any action regarding potentially early withdrawals from your retirement accounts, be sure to consult with a licensed tax professional.
It’s important to consider how you can take advantage of the benefits that retirement accounts offer. Fisher Investments’ financial and retirement planning professionals are committed to helping investors define their financial goals for a secure retirement and create a customized plan for achieving them.
Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns. Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations. The foregoing constitutes the general views of Fisher Investments and should not be regarded as personalized investment advice or a reflection of the performance of Fisher Investments or its clients. Nothing herein is intended to be a recommendation or a forecast of market conditions. Rather it is intended to illustrate a point. Current and future markets may differ significantly from those illustrated here. Not all past forecasts were, nor future forecasts may be, as accurate as those predicted herein. The contents of this webpage should not be construed as tax advice. Please contact your tax professional.
i Source: Internal Revenue Service, as of 4/16/2018. IRS FAQs - Contributions. https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras-contributions.
ii Source: Internal Revenue Service, as of 4/16/2018. IRS Tax Topics, Topic Number 558. https://www.irs.gov/taxtopics/tc558.
iii Source: Internal Revenue Service, as of 4/16/2018. IRS Retirement Topics, Exceptions to Tax on Early Distributions. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions.