IRA vs. 401(k) – What’s the difference?

IRA vs 401K
« Return to Learn

Yesterday’s retirees collected pensions and bought condos in Florida. Tomorrow’s retirees could find themselves eating 8-bit sushi in 3D-printed houses on Mars.

The world is changing, and so are retirement plans. Pensions have all but disappeared, replaced by defined contribution plans you can pay into throughout your career and then live on when you retire. The average employee changes jobs a dozen or more times and defined contribution plans let you take your investment wherever you go so you can keep building up your wealth.

Today’s workers typically choose between two basic types of retirement plans: an IRA or a 401(k). Both leverage the power of compound interest to grow your money in a tax-deferred account, but there are some key differences between them. Here’s what you need to know to choose the plan that’s right for you.

401(k)s: Employer-sponsored retirement plans

Employers don’t always offer a retirement plan, but when they do, it’s usually a 401(k).

With an employer-sponsored 401(k), you can contribute up to $18,500 of your pre-tax income in 2018 — or $24,500 if you’re over 50 and the 401(k) plan permits it. Some employers even offer matching contributions to help you grow your money faster. For example, your employer might match the amount you put in up to a certain limit, usually between 3 and 6 percent of your earnings.

Anytime you’re offered matching contributions, you should consider putting in at least as much as your employer will match. Think of it this way: You wouldn’t turn down free money, would you?

With a 401(k), your eligible contributions help lower your income tax each year since you won’t have to pay taxes on the money until you start making withdrawals, or “distributions.” At that point, your distributions will generally be taxed at the same rate as your paycheck. The higher your tax bracket at the time you withdraw the funds, the more you’ll have to pay in taxes — regardless of what your tax rate was when you made the contributions.

Some employers may offer a Roth 401(k) plan, which gets taxed differently. The money you contribute to a Roth retirement plan gets taxed before you make your contribution, so you don’t have to pay taxes when you make qualified withdrawals. You also won’t have to pay taxes on any earnings when distributed as a qualified distribution. When you make a qualified withdrawal, you’ll only be taxed for matching contributions your employer made.

IRAs: Retirement plans for everyone

What if your employer doesn’t offer a retirement plan?

In that case, an IRA (Individual Retirement Account) is an investment option that’s available to anyone under 70½ years old. Like a 401(k), a traditional IRA lets you invest pre-tax income — up to $6,500 in 2018, depending on your age and taxable income. It’s a good option if you expect to be in a lower tax bracket when you retire, since you can get a break on your taxes now and pay a lower rate when it’s time to withdraw the funds.

A Roth IRA, on the other hand, functions much like a Roth 401(k) plan. The money you contribute is taxed beforehand, so you won’t have to pay when you make eligible withdrawals. The key difference is that with a Roth IRA, you can withdraw your money (although not necessarily the earnings) penalty-free at any time. This makes it a great investment if you’re in the early stages of your retirement planning and want to have access to your funds for other life goals, like buying a home or getting married. And since there’s no age limit on a Roth IRA, you can continue investing as long as you like.

Learn more about the eligibility requirements and benefits of a Roth IRA.

Which is right for you?

If you’re eligible for both a 401(k) and an IRA, which should you choose?

That depends on your financial situation. If you can afford to contribute to both, you’ll be on the road to a well-funded retirement. If you have to pick one, there are a few things to keep in mind.

Matching contributions for the win: If your employer offers a 401(k) with matching contributions, take it. The contribution limits are much higher than an IRA, and with help from your employer you can build your funds much faster. Again, free money.

Rolling it over: When you leave your job, your matching contributions will end and you won’t be allowed to contribute to that 401(k) anymore. If your new employer offers a 401(k), you can have the funds rolled over into your new account. If not, you have other options, for example: Leave your money where it is — you’ll still have access to it, even if you can’t contribute — or roll it over to an IRA with lower fees.

Maximum flexibility: If your employer doesn’t offer a retirement plan with matching contributions, consider an IRA. If possible, contribute as much as the IRS will allow. An IRA often gives you more investment options than a 401(k), allowing you to invest in a wide variety of mutual funds, exchange-traded funds, stocks and bonds.

At OCCU, we offer a number of retirement planning options, including IRAs. Our expert team can help you determine which type of investment makes the most sense for you. Contact us to learn more!

Note: The above information is not intended as tax advice. Please consult your tax professional for tax information.