Most people generally seek to retire comfortably. Whether you are approaching retirement or you are in the middle of your career, you may have questions about which type of retirement account is best for you. In this article, we’ll primarily discuss some important differences between traditional Individual Retirement Accounts (IRA) and company-sponsored 401(k) plans. Both offer the opportunity to save money for retirement with the objective of making that money grow.
Is one account 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.
Traditional 401(k)s let you contribute pre-tax money to an account. Similarly, in most cases, traditional IRA contributions may be tax-deductible. These savings benefit from compound growth on a tax-deferred basis. Ordinary income taxes are due upon future withdrawals. Employers may also contribute to an employee’s traditional 401(k) via 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-sponsored plan; a traditional IRA is a retirement savings account and is typically set up by an investor with earned income 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. Pre-tax 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traditional 401(k) grow on a tax-deferred basis and, along with the 401(k)’s earnings, aren’t taxed until the money is withdrawn.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 limit employees to invest their money in their choice of company stock or a limited number of mutual funds that have been pre-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 they either roll pre-tax dollars into the account from another pre-tax retirement account or contribute after-tax dollars (which they may be able to deduct from taxes depending on their income). Only the investor or designated agent can make decisions regarding the account. A traditional IRA may offer more investment flexibility than a 401(k), depending on the retirement plan’s restrictions.
The contribution limits of 401(k)s are higher than those of an IRA, although these limits can change from time to time. For 2021, the annual contribution limit for 401(k)s is $19,500, and account holders who are 50 years of age or older can make additional “catch-up” contributions of up to $6,500 per year.i
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 2021 tax year, limits are $6,000 or $7,000 for account holders who are 50 or older.iI
Both traditional 401(k) plans and IRAs allow contributions to grow on a tax-deferred basis until you make withdrawals during retirement. All qualified withdrawals during retirement are taxed as ordinary income in the year the distribution occurs. Contributions to a traditional 401(k) plan are pre-tax, meaning the contribution amount is paid from the employees’ earnings before income taxes are calculated and withheld, while traditional contributions may be fully or partially tax-deductible subject to income limitations.
Another type of IRA is a Roth IRA. In contrast to a traditional IRA, you cannot deduct contributions to a Roth IRA. However, a Roth IRA offers tax-free growth and tax-free withdrawals for qualified distributions. So, 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. 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 Roth 401(k) option, which combines some features of a Roth IRA and a traditional 401(k). Contributions to a Roth 401(k) are made on an after-tax basis, but growth and future qualified withdrawals are tax-free. However, any matching contributions made by your employer must still go into a traditional 401(k) account and, along with capital gains from the employer match, will be taxed as ordinary income when withdrawn. As with a traditional 401(k), your ability to participate in a Roth 401(k) is not subject to 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.iii 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.iv
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, your retirement accounts may allow you to take withdrawals without any penalty if you become disabled and can no longer work. Before taking any action regarding 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 02/11/2021. Retirement Topics – 401k and Profit Sharing Plan Contribution Limits.
ii Source: Internal Revenue Service as of 02/11/2021. Retirement Topics – IRA Contribution Limits.
iii Source: Internal Revenue Service as of 02/11/2021. Topic No. 558 Additional Tax on Early Distributions from Retirement Plans Other than IRAs.
iv Source: Internal Revenue Service as of 02/11/2021. Topic No. 558 Additional Tax on Early Distributions from Retirement Plans Other than IRAs.