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While many individuals choose to take advantage of both and IRA and a 401(k) to save for retirement, some cannot afford to use both accounts and max out their contributions, and they may need to determine which plan is right for them. Today, we will explain the major differences between IRA and 401(k) savings plans so you can decide which is more beneficial for your retirement.

Need assistance planning for retirement? Contact the financial advisors at The Templeton Group of Cornerstone Financial Management today to request a consultation.

401(k) Plans

Named after section 401(k) of the Internal Revenue Code, a 401(k) plan is a defined-contribution pension plan sponsored by your employer that employees fund with their paycheck directly and your employer may match. Contributions into this kind of tax-deferred retirement savings account are made pre-tax, and the investment income is accrued and compounded tax-free. As long as you are older than 59 ½, your withdrawals from this account are taxed at the normal rate.

Currently, you can contribute a maximum of $19,500 per year to a 401(k)—while those 50 and older can make an additional $6,500 catch-up contribution. Additionally, some employers now offer Roth 401(k)s, which function like traditional 401(k)s but allow for tax-free qualified withdrawals and are funded by after-tax contributions that are not tax deductible.

IRAs

An individual can set up their own tax-deferred retirement savings account, or an IRA. Like a 401(k), your contributions are typically tax-deductible in a traditional IRA and your earnings, and returns are tax-free while your withdrawals are taxed. In a Roth IRA, you make after-tax contributions, but your withdrawals are tax-free when certain conditions are met. You can currently contribute a maximum $6,000 to a traditional or Roth IRA, with an added $1,000 catch-up contribution if you are 50 or older.

Additionally, employers can offer SEP and SIMPLE IRAs for their employees. Only your employer can contribute to an SEP IRA, but these accounts have higher contribution limits than traditional IRAs. An employer in 2020 can contribute up to twenty-five percent of an employee’s annual salary provided the contributions don’t exceed $57,000. A SIMPLE IRA has a different contribution mechanism, whereby an employer can do one of two things: match an employee’s annual contribution up to 3% or have a non-elective contribution of 2% of an employee’s salary. The contribution limit for a SIMPLE IRA is $13,500, with an additional catch-up contribution of up to $3,000 for those 50 and older.

Choosing a 401(k)

Some might suggest that a 401(k) is a good choice because of the potential employer match and high contribution limit, allowing for much quicker growth compared to an IRA. Since a typical employer match will be somewhere between two and ten percent, a 401(k) can generate a significant amount of earned income.

401(k)s offer a few other distinct advantages over IRAs, including the ability to take out a loan on the account. While the rules differ between 401(k) plans, you’ll have an interest rate and repayment period like a normal loan. 401(k)s are also more secure from creditors in most states, since typically the only creditors and individuals that can get at the funds in the account are the IRS or your spouse.

Choosing an IRA

While the pro-401(k) argument has merit, an IRA has unique advantages as well that can make it attractive to those planning for retirement.

First, if your employer doesn’t offer a 401(k) plan, then you simply don’t have the option to get one but can still open an IRA. On top of that, opening an IRA can take as little as a few minutes and you can start saving immediately, while many 401(k) plans have waiting periods before employees are eligible to join.

Second, IRAs tend to offer a far wider array of investment options. Both 401(k)s and IRAs offer different ways to invest your money, but a 401(k) usually has basic investment vehicles like money market funds and S&P 500 index funds while an IRA can offer everything from stocks and bonds to mutual funds and ETFs. If you are intending to place your money into a certain type of investment, an IRA may be the right choice.

The downside, arguably, is that an IRA requires more user input, and for those without significant investment knowledge, a 401(k) offers simpler and generally efficient choices to invest without having to learn the full gamut of investment options at hand in an IRA.

Retirement Plan Options When Leaving an Employer

When leaving your employer, you may have concerns about what to do with your retirement plan funds. A plan participant leaving an employer typically has four options. You may engage in a combination of these options, with each choice offering advantages and disadvantages:

  • Leave the money in your former employer’s plan, if permitted
  • Roll over the assets to your new employer’s plan, if one is available and rollovers are
  • Permitted
  • Roll over to an IRA
  • Cash out the account value

The Bottom Line

All in all, if you can afford to have both a 401(k) and an IRA, that may help you save more money for retirement than either option alone. For those who want a generally more secure retirement plan and are willing to give up more precise control in the investment options, a 401(k) may be preferable. For those interested in saving their money through particular types of investments and who aren’t as concerned about the security of their plan from creditors or lawsuits, an IRA may be more ideal. Ultimately, the right choice will depend upon who you are and what you want to do with your money.

Get Retirement Planning Help

An experienced financial advisor from The Templeton Group can help you understand which retirement savings plan may be best for you. We can also help you understand contribution limits, withdrawal implications and more. And we can assist you with making investment decisions within your 401(k) or IRA based on your goals and risk preferences. Contact us today to set up an initial consultation.

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