The most important action is that you actually save for retirement; however, many investors still wonder whether it is better to save to an IRA or a 401(k). Both IRAs and 401(k)s are tax-favored retirement accounts, so generally, any withdrawals before age 59 ½ will incur a 10 percent early withdrawal penalty. Still, there are differences between the two types of savings plans that you should understand before you start saving.
The main difference that most financial experts will point out is the contribution limits. For 2019, you can contribute $6,000 to an IRA plus a $1,000 catch-up contribution if you are 50 or older. Compare that to a 401(k), where the contribution limit is $19,000 with a $6,000 catch-up contribution for 50 and older. Most advisers will steer you toward the 401(k) because of how much more you’re able to save. But, let’s be real—not everyone can afford to save $19,000 a year. Most American workers save around 6 percent of their salary to their workplace retirement plan, which amounts to around $2,800 annually.
So, if you’re saving far less than the contribution limits, does it matter which account you save to? Well, it depends on your goals. First, I generally recommend saving to your 401(k) because there is likely an employer match up to a certain percentage. This is free money your employer adds to your account for your participation—and if you’re only saving $2,800 a year, every little bit helps. If 6 percent of your salary is $2,800, and your employer match is the average 3 percent, that is an extra $1,400. Looking at it another way, the employer match gives you an automatic 50 percent return. Where can you get that today?
A 401(k) is automatically taken from your paycheck before taxes, so not only are you saving on how much tax you pay throughout the year, the money never hits your bank account, so you don’t notice it missing. For many, it is much harder to save each month when you have to remember to make your IRA contribution, especially when there are bills that need to be paid and stuff you want to buy. Furthermore, your tax break isn’t immediate, as IRA contributions are deductible when you’re filing your return, assuming you are under the income limitation.
While that is a lot of checks for the 401(k) column, let’s look at an IRA. With an IRA, you have significantly more flexibility in your investment choices. You may also have a professional adviser manage your investments. While that is not a guarantee your account won’t lose money, it can reduce the “investing mistakes” people are prone to make, like not monitoring their portfolio, ignoring tax consequences, or pulling money out of the market when volatility picks up.
Another aspect you may want to consider is the access to your money. Many 401(k) plans have loan provisions that allow you to borrow against your balance with favorable terms. While most financial advisers will not recommend this, in an emergency, this can be a low-cost source of funds compared to a consumer loan. Borrowing against your IRA is prohibited; however, you can generally withdraw money from an IRA for certain higher-education expenses and for first-time home purchases (among a few other exceptions) without incurring an early-withdrawal penalty.
While the choice between an IRA and 401(k) can seem complicated, remember the most important action is actually saving the money in the first place. In the coming weeks, I’ll be comparing a Roth IRA vs. a 401(k) and a traditional 401(k) vs. a Roth 401(k).