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401(k) vs. IRA: Pros, Cons, and Comparison

The pandemic has made many of us conscious of our spending, employees included. As a result, when it comes to employees, even people who just graduated and are in their 20s are looking to save up for retirement plans.

So, whether your employees belong to the near-retirement age or not, it doesn’t matter because they have started considering saving up for retirement sooner or later. In this regard, offering retirement benefits to employees has become one of the top trending compensation plan elements in 2022.

So, if you are offering financial advising to your employees and contributing to their retirement plans, it is good to understand the two major types of retirement plans: the 401(k) and the IRA or the Individual Retirement Account.

This article talks about the differences between the 401(k) and the IRA and lists the pros and cons of each retirement saving option.

What a 401(k)?

A 401(k) is a type of retirement plan only accessible to employees if the employer offers it. This is a retention strategy in which the employee is bound to work for the company for a specified period before becoming eligible for the 401(k).

Defined Contribution

Since it is workable only through an employer, employees can contribute a part of their salary to the plan sponsored by the company. In other words, it is known as the defined contribution plan. So, an employee willing to participate in a 401(k) gets a salary after the deduction of the amount that goes into this retirement fund.

However, it is also possible that under a retention strategy, the company matches the contribution and no deductions are made whatsoever from the employee’s paycheck. The employer can match anywhere from between 2-10% of the employee’s salary which is dependent on the employee’s performance.

Choice of Investment

One benefit is that the 401(k) allows the person to choose the type of investment they want to make. They can choose from a range of mutual funds. However, the level of contribution in a 401(k) is dependent on the age. An employee younger than 50 can contribute no more than $20,500 to a 401(k) account in 2022. However, above the age of 50, this amount rises to a cumulative of $27,000. There might also be some limits set for employees that are highly compensated. So, your 401(k) limit depends on the salary you take home.

Withdrawal Limit

Furthermore, to withdraw your funds you will have to wait till you are 59.5 years old, otherwise you will face a 10% early withdrawal penalty. However, even then there are some exceptions if you leave your job at 55 or you can delay the required distribution if you are working over the typical retirement age. However, after the age of 72, the person is required to take out some required minimum distributions.

Types of 401(k) Plans

A traditional 401(k) plan’s contributions are not subject to tax deductions. However, the amount when withdrawn will be tax deducted based on ordinary income rates.

A Roth 401(k) investment grows and is withdrawn tax-free. This means that any contributions made to the fund will be subject to tax deduction before they are added to the account.

401(k) – Pros and Cons

Pros

  • The 401(k) has a higher contribution limit compared to the IRA.
  • The employer can match the contribution which acts as an additional retirement benefit.

Cons

  • There are limited investment options available in the 401(k)
  • Not everyone can opt for a 401(k) as it is tied to employment.

What is the IRA?

The IRA is another type of retirement fund which is can be employer sponsored or not connected to the employer. Any employee who has earned income can invest in this retirement fund except for some exceptions in the case of non-working spouses. For that also, the married couple would have filed a tax return jointly to qualify for the non-working IRA.

Choice of Investment

People under 50 can invest up to $6,000 in their IRA account. When they turn over 50, the contribution limit increases to $7,000. Like the 401(k), the IRA also allows a choice of investment.

Withdrawal Limit

Similar to the 401(k), the IRA also has an age limit of 59.5 years to withdraw the funds. Withdrawing them any earlier will result in a 10% penalty alongside taxes deducted from the amount.

If the employee has invested in the Roth IRA, they do not have to wait to turn 59.5 years to withdraw the funds. The only condition is that the account is at least 5 years old and is a Roth account. That being said, it is possible to convert a traditional IRA to a Roth IRA account.

Furthermore, both the traditional and Roth IRA plans have early withdrawal exceptions like layoffs and health insurance and college costs after the layoff.

Types of IRA Plans

The traditional IRA plan does not deduct taxes on the amount invested. However, when the amount is withdrawn, it is subject to taxes.

The Roth IRA’s contributions are subject to taxes at the time they are put into the account, but the withdrawals are not subject to tax deductions.

IRA – Pros and Cons

Pros

  • The IRA is accessible to anyone and can be employer-sponsored or not tied to the employer
  • IRAs have a wider pool of investment opportunities including bonds, stocks, ETFs, and index funds.
  • There is no age restriction to the withdrawal of funds.

Cons

  • It has a lower contribution limit compared to the 401(k)

401(k) vs. IRA – The Differences

The major difference between the 401(k) and the IRA is that one is tied to the employer and has a higher contribution limit while the other one has a lower contribution limit and can be employer-sponsored or not.

In this regard, anyone who wants to save money for retirement can invest in the IRA since there is no limitation on withdrawing the funds after a certain age. The person can withdraw the funds after 5 years from the first contribution in a Roth IRA. Therefore, it can act as an investment fund rather than a retirement fund for people of all ages.

401(k) vs. IRA – The Verdict

While there are significant differences between the 401(k) and the IRA, if the employer is offering the 401(k) as an added benefit, the employee should take it since it is a strong retirement fund with a considerably higher contribution limit.

However, the IRA is suitable for anyone who wants to secure a future and is not tied to an employer. If they are looking for a way to save, they can invest in the Roth IRA and withdraw their funds 5 years after the first contribution.

Both retirement options are well-suited to different situations, therefore, there cannot be a single winner in the race. However, within the IRA, the Roth IRA is probably the one offering greater benefits because the amount can be withdrawn from the fund tax-free at any time and penalty-free after five years, even if the person has not turned 59.5 years.

Summing it Up

401(k) and the IRA are the two major types of retirement funds available. While the 401(k) has become a common retirement scheme to retain employees and maintain their performance over a specified period, an IRA is a retirement fund that any person can contribute to given that they are earning an income or married to an income earner.

Both the 401(k) and the IRA have pros and cons based on the contribution limit, the penalty-free withdrawal conditionality, and accessibility. So, the final selection of the retirement plan depends on one’s circumstances.

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