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When we are young, we think the world belongs to us. But year after year we realize that one day we will be like our grandparents. Retirement will not seem as bleak as we might have expected if you have planned accordingly.
Don’t rely on pensions but rather take matters into your own hands. What can you do? You can open a retirement plan and make each month small contributions. What’s more, your employer can take part and also contribute to your account. What options do you have?
Well, the two most common types of retirement accounts are an IRA (Individual Retirement Plan) and a 401k. Even though both have the same mechanism and offer a great tax benefit, they have their differences as well. Thankfully, you don’t have to choose between the two because you can have them both if you wish.
401(k) or IRA – Which Of Them Is a Better Choice For You?
Before you start doing anything, you need to know how they function, what their differences and benefits are. Let’s get started.
What’s a 401k?
Simply said, this is a retirement plan which companies offer their employees. Other similar plans are 403b and 457. You can open a 401k plan only if your employer offers it. If that’s not the case, most probably you need to learn more about IRAs and use it.
In addition to that, some employers will contribute to your account the same amount of money you contribute; the so-called matched contribution. For instance, if you dedicate 5% of your salary to your 401k account, your employer can match this amount.
A great advantage of a 401k account is that you don’t have to pay taxes on the money for the time being. Only when you start withdrawing funds will you have to pay taxes.
However, there are certain limits to the amounts of tax-free money an employee can contribute. In 2015, this limit was $18,000. As of this year, the limit is increased to $18,500. These amounts might increase following increase in the costs of living. If the person is over 50, they can contribute additional $6,000.
Benefits of a 401k plan
Higher Contribution Limit
A 401k account has a significantly higher limit for a pre-tax amount of money compared to an IRA. Currently it stands at $18,000 per year but can be increased due to cost-of-living adjustments. As for both traditional and Roth Ira, the limit is only $5,500.
Keep in mind that these are the perfect conditions. Often, employers might impose contribution limits regardless of how much the government permits you to save. For instance, your employer limits your contributions to 15 of your salary which is $60,000 per year. This makes only $9,000 annual pre-tax contribution.
Sometimes companies make the so-called matching contributions to an employee 401k. This amount can be up to 6% of the employee’s annual salary. Depending on the company, this percentage can go even higher. This, on the other hand, will lead to higher returns on your account.
Borrow From It
Yep, that’s good news. You can use your 401k account to take out a loan. If you give back the money you have borrowed, you will not be penalized.
Usually, you don’t have the right to withdraw money from your retirement account before a certain age unless you want to pay a penalty for doing so. Sometimes an employee can take out some money for medical purposes. If you have the medical bills and they are tax-deductible, you can qualify for this. In addition, disabled people can also make free of charge withdrawals.
401k plans offer their owners investment options as well. You can choose from a wide range of investments. Some of the companies offer the employees to invest in the company stock at a lower price.
The amounts of money you would like to contribute will be taken from your paycheck. This is an easy and simple process without your having to make any payments.
What’s an IRA?
IRA stands for Individual Retirement Plan, and unlike a 401k plan which is provided only by employers, you can have an IRA as an individual. Anyone who is under 70 can have an IRA , there are no limits.
There are many types of IRA but two main types are Traditional and Roth. When it comes to paying taxes, they have some differences. A traditional IRA offers tax-deductible contributions, while a Roth IRA contributions are not. If you have a traditional IRA, you are free of taxes on capital gains, dividends, interest and rents.
Both IRA accounts have limits to the amount of money you can contribute per year. As of 2018, this amount is $5,500 and if you are over 50 – $6,500. In addition, you may not be able to qualify since there are some requirements regarding the annual income. If you are single, the gross income should not exceed $120, 000. If you are a family, the combined gross income should be below $189,000.
Benefits of IRAs
What are the advantages of IRAs over 401k? Let’s take a look.
A Wide Range Of Investments
Both 401k and IRAs offer investment option to their holders. According to a Plan Sponsor Council of America survey, 401k accounts offer up to 19 mutual funds. Unlike it, IRAs offers a lot more than that – up to 200.
For instance, Fidelity offers almost 200 mutual funds, while T.Rower Price have in their pocket around 100. Some companies, including Fidelity, can also provide you with the opportunity to invest in mutual funds offered by other companies. That makes the numbers increase to several thousand different funds.
Low Costs And Expenses
If we have to compare a 401k with an IRA, definitely the latter beats it when it comes to price. A 2012 survey carried out by the Investment Company institute revealed that each investors owning a 401k had to pay $6,30 fee for a $1,000 invested in a fund. That’s pretty high compared to IRAs which offer a no-load mutual fund investment.
If you have a 401k, you will also have to pay additional fees and charges which will eat away your profits.
That’s tricky when you have a retirement plan. According to rules, you cannot withdraw money unless you have turned 59 and a half. If you do so, you have to pay, a penalty which is usually 10%. In addition, you will have to pay taxes on the money and won’t be able to benefit from the pre-tax advantages.
Despite this, there are some conditions that allow you to distribute money without having to pay a penalty. These are applicable only to IRAs!
One of the specific exceptions is when a first-time homebuyer needs up to $10,
000 for a down payment. In addition, IRAs give you the chance to withdraw free-of-charge money for educational purposes.
Which One Is For You?
Now you know what a 401k and an IRA are. You know how the work and their advantages. The main difference between them since they both are retirement accounts is that one of the is offered only through an employer.
If you work for a company that gives you the chance to have a 401k, maybe you should accept the offer. Not only are the limits of 401k higher but also the employer might contribute additional money to your account. This will make sure your money grows at a higher rate.
In case the company you work for doesn’t offer 401k or doesn’t make matching contributions, you might consider an IRA. Furthermore, not all companies are willing to make matching contributions. This would seriously erode the potential of a 401k retirement plan.
If you are a young man who is at his height, most probably a Roth IRA will make sense.
When you are young and capable you can pay your taxes while they are still relatively and you can actually afford them. On the contrary, if you earn a lot of money at the time of contributions, perhaps it will be better to choose a traditional IRA. Why? Well, large amounts of money mean lots of taxes.
It’s never too early to think about the future, including the day when we retire. In my opinion, opening a retirement plan is very important since it guarantees less stressful and happier days as a senior.
The two most common ways to do so is by either opening a 401k or IRA account. Both have their benefits and drawbacks, and in the article they are outlined. The final decision is yours.