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401(k) vs. IRA: Comparing and contrasting

January 2017 / Share
While both of these financial instruments have the same basic goal in mind, they go about it in slightly different ways.

Saving for retirement is essential for most workers, not to mention more than a little daunting. While the process itself can be complicated and involves a fair amount of planning, the wide range of options available to retirement savers makes the prospect less intimidating. Two of the most popular ways to grow a nest egg are 401(k) funds 3rd party Link Informaiton and Individual Retirement Accounts 3rd party Link Informaiton. While both of these financial instruments have the same basic goal in mind, they go about it in slightly different ways. There are also benefits and drawbacks involved in each. Ultimately, choosing between the two requires a basic assessment of which option seems most straightforward for your situation.

401(k) and IRA basics

Both 401(k) funds and IRAs are ideal retirement savings choices for two basic reasons. Primarily, they tend to make investing for the purposes of saving relatively easy. Each of these funds can either be managed by a financial advisor chosen by the investor or their company. The funds are also commonly placed in mutual or index funds, which pool money and distribute some of the risk involved in any kind of investment strategy.

The other main advantage of these accounts is their tax preferred status. In general, the money placed into a 401(k) or IRA is tax deductible, so it does not add to the investor's taxable income. This can mean investors using these accounts may owe less on their annual tax returns, or even receive a sizable tax refund. The exact way tax liability is determined depends on the exact type of account. Both 401(k) funds and IRAs are available as either "traditional" or "Roth" accounts.

  • Traditional 401(k) fund contributions or IRAs are tax deductible, while withdrawals are taxed as ordinary income. This usually means any money placed into a traditional account is not subject to taxation until it is withdrawn, at which point it will be taxed at the applicable rate. 
  • Roth IRAs or 401(k) funds allow "post-tax" contributions. This means money placed into these accounts can be taxed at the time of deposit, but can be withdrawn from the account tax-free. 

Choosing between a traditional and a Roth account depends on a number of factors, including your anticipated retirement date and income.

Primary differences

Where do 401(k) accounts and IRAs differ? For starters, a 401(k) isn't available for everyone. These funds are generally offered through one's employer, and the investment options they offer are usually more limited than an IRA. While this tends to result in a more limited choice from the worker's perspective, this could be favorable for those who prefer a more streamlined approach. Contributions to a 401(k) may also be matched by an employer, which can function like a bonus and provides an additional incentive for workers to stick with a company. But since 401(k) plans are managed by an employer, they may impose limits on who can participate, who qualifies for a match or how long an employee must contribute before the funds are vested.

Contribution limits: Both accounts come with their own annual limits on how much investors can contribute. As of 2016, the standard limit is $18,000 per year for a 401(k) and $5,500 per year for an IRA. If the account holder is age 50 or older, they qualify for the "catch-up" limit of up to $24,000 per year for a 401(k) and $6,500 for an IRA.

Retirement Know your retirement strategy and goals before choosing between a 401(k) and IRA.

Which is better?

Again, there's no perfect solution to everyone's question of which account they should choose. Each option offers benefits that work in favor of some but might be less advantageous to others. In addition, no two accounts are precisely comparable since they can all be tied to different investments with varying fees and restrictions. 

One final yet important consideration when using these retirement accounts: Don't save more than you can afford. Contributions to savings should be second only to basic expenses like rent and food. Suggestions on how much to save per year vary widely, but there's no rule that says you must contribute up to the limit on your 401(k) and IRA. If you are able to accomplish this easily, it would be an amazing achievement. But keep in mind that it's often better to start early, save steadily and finish strong with retirement funds.

Vectra Bank can help you manage your retirement savings.


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