401(k) or IRA: What’s the Difference?

I went out to dinner with some friends the other night and we started talking finances. My friend Connor and I got into a debate about whether it’s better to invest in IRAs or 401(k)s. I’ve always been in favor of 401(k)s because they’re so easy to use but I’ve heard on more than one occasion that people prefer to use IRAs. So which account is right for you?

What’s a 401(k)?

Before we get into the details, let’s talk about what a 401(k) is. The name 401(k) comes from section 401, subsection k of the Internal Revenue Service Tax Code where these types of accounts are specified. A 401(k) is an employer-sponsored retirement account that’s typically offered to employees as part of their benefits package. If your employer offers a 403(b), 457, or Thrift Savings Plan instead of a 401(k), these are essentially the same as a 401(k). You just happen to work for a non-profit or government agency.

The reason 401(k)s are so special is because of the tax rules that apply to contributions. 401(k)s are tax advantaged which means they provide some form of tax benefit. We previously looked at the way taxes affect our overall income in my article on IRAs, seen below.

If you’re a single adult and have a $60,000 salary, you’re actually only taking home about $52,260 after paying taxes!

The taxes don’t stop there. Let’s take our single adult above and call her Tommy… Of the $52,000 Tommy took home for the year, she was able to invest about $10,000 of her money and made an 8% return for $800. Before Tommy can celebrate though, Uncle Sam comes over and says that those $800 Tommy made count as income and she needs to pay tax on them. At Tommy’s current tax bracket, that’s 24%. Tommy has to pay $192 in taxes on her profits. In fact, if Tommy continued to see her $10,000 investment grow, at 8% annually, over 30 years she would end up with an account balance of $58,000 but would have paid $15,000 in taxes!

After all is said and done, Tommy has [paid] almost $8,000 in taxes for the year!

So how can a 401(k) help with taxes, such as in the situation above? There are three major benefits to 401(k)s.

The first is the fact that all contributions are tax deferred. Being tax deferred means taxes on the funds are deferred until a later date. In the case of 401(k)s, all contributions are tax deferred so contributions aren’t taxed when put into the account. Since the contributions aren’t taxed, they don’t count towards your taxable income. In Tommy’s case above, if she contributed $5,500 of her income towards a 401(k), she would only owe taxes on $54,500 instead of the full $60,000. This lowers her tax bill by $1,200!

But you don’t get away without paying taxes at all. The taxes are assessed when the funds are taken out during retirement. Hence the deferred part of tax deferred. When the funds are removed, they’re taxed at your current tax rate. If you anticipate your tax bracket to be lower in retirement, which is the case for most people, this can be a double benefit since you won’t have to pay taxes now and you’ll pay less in taxes in the future.

The second benefit to 401(k)s is that all growth in your funds is tax free. Tax free funds are exactly what they sound like. There are no taxes assessed on them. In the example above, Tommy would have kept all $800 of her profit. On top of that, her funds would continue to grow tax free so she wouldn’t have to pay any of the $15,000 in taxes either. She could instead reinvest those funds and her account would be worth over $100,000 in 30 years!

Finally, most employers who offer 401(k)s also offer some sort of matching program. This means that your employer will match your contributions up to a certain amount. This is literally free money. A common benefit is 50% of contributions up to 6% of income. In Tommy’s example, if we assume her employer matches 50% up to 6% of income, when she contributes $3,600 to her 401(k), her employer will also contribute $1,800. Her 401(k) account now has an additional $1,800! If you’re not sure what your company’s specific match is, check with your human resources department.

The one drawback to funding 401(k)s is that the funds aren’t available until you’re 59½. If you do decide to withdraw the funds before you reach age 59½, you’ll have to pay a 10% fee on top of the income taxes on the distributions. There are some exceptions to this rule, but in general, you should plan on not being able to touch the funds until you retire.

Differences Between 401(k)s and IRAs

If you read my article on IRAs, all of this probably sounds very familiar to you. That’s because 401(k)s and IRAs share almost all the same qualities. So how are you supposed to choose which account to fund?

Let me start off by saying it’s not an “either/or” situation. You can fund both a 401(k) and an IRA. Ideally you would max out your contributions to both but that may not be feasible. I’m personally not at a point where I can max out both accounts right now. So if you have to choose between them, let’s take a look at the differences.

The biggest difference is the employer matching that often comes with 401(k)s. As mentioned above, most employers will provide some sort of matching for your contributions to your account. There’s just no such thing with an IRA.

The second thing that 401(k)s have going for them is higher contribution limits. IRAs have a contribution limit of $5,500 per year ($6,500 if you’re 50 or older) so you can’t contribute more than that to your IRA in a given year. 401(k)s on the other hand have an $18,500 limit ($24,500 if you’re 50 or older) as of 2018. This limit doesn’t include employer contributions so you can contribute $18,500 without affecting the extra money your employer matches. The overall limit for contributions, including employer contributions, is $55,000 per year as of 2018.

Now, remember when I said 401(k)s and IRAs share almost all the same tax benefits? Depending on your income, there could be differences. If you also have access to a retirement plan at work, such as a 401(k), the reduction to your taxable income from IRA contributions starts to phase out once you make $63,000 for single individuals or $101,000 if you’re married. The table below from the IRS website shows how your income affects your ability to reduce your taxable income. If you’re in the category that only allows for a partial deduction, use this worksheet on the IRS website to determine how much you can deduct from your income. So, if you don’t qualify for a tax deduction based on your income, you lose one of the main benefits of an IRA. There are no income limits on 401(k) benefits. Money put into 401(k)s is always tax deferred, so you can always reduce your taxable income using 401(k) contributions.

401(k)s also have the advantage of being deducted straight from your paycheck. If you never see the money, you won’t miss it. It automates your saving for you so you don’t have to think about it.

But IRAs do have one significant advantage over 401(k)s. With 401(k) accounts, the options for investing are usually limited to a specific set of mutual funds chosen by your human resources department. These funds may not match up with what you want and the expenses associated with the mutual funds may not be ideal. Whereas with IRAs, you’ll have the option to invest in individual stocks and bonds as well as your choice of ETFs and mutual funds. This flexibility allows you to shop around for cheap investments and find the right ones for you. Just make sure you have at least these two investments in your portfolio.

Which Account Should You Choose?

As I mentioned above, ideally you would fund both a 401(k) and an IRA to their maximum contribution limits. But if you can’t, here’s what I do and why.

First, I make sure to put in at least as much as my company’s match. If you don’t do that, you’re literally leaving money on the table. If your company has a 50% match up to 6% of your income, putting in 6% is like instantly getting a 50% return on your investment.

After that, I make sure to max out my IRAs. I like to put my money into my personal portfolio in my IRA account so that I have more control over what I invest in. I also can’t get my two favorite investments in my 401(k) so I prefer to fund my IRA.

Lastly, I put as much as I can into my 401(k). Since the IRA limit is relatively low, I always plan on maxing that out for the year. Since I don’t want Uncle Sam to tax my income, I continue to put funds into my 401(k).

When I get to the point where I’m maxing out my IRA and 401(k) (yes, I said when), I’ll continue to invest money into my personal investment accounts outside of the IRA and 401(k). Even though it’s no longer tax advantaged, it’s better than letting inflation eat away at my purchasing power.

If your employer offers a 401(k) and you’re not contributing enough to get the full match, you need to do that now. Once you have the full match, whether you continue to invest in your 401(k) or IRA is really up to you. As long as you’re investing your money, you’ll eventually find that you have enough for a comfortable retirement.