A 401(k) versus an IRA: What’s the Difference and How to Choose?

There are two common accounts used for retirement saving: A 401(k) and an Individual Retirement Account (IRA). Both provide major tax benefits, but which is right for you? And what’s the difference? 

At Scarborough Capital Management, we specialize in 401(k) plan management and we hear these questions a lot, specifically, the 401(k) and IRA similarities and differences. So, let’s take a look at what these plans are and how they compare. 

 

Scarborough Capital Management specializes in 401(k) plan management. Contact our team of financial advisors to see how we can help. 

 

A 401(k)

A 401k is an employer-sponsored plan, meaning you can only have one if your workplace offers it. We will focus on three types of common 401ks: Traditional, Roth and Solo.

Traditional 401(k)

A Traditional 401(k) is what most people talk about when they mention 401(k)s. Your payroll department will take contributions to this plan out of your paycheck before taxes, and you don’t pay taxes until you start taking withdrawals in retirement. 

Roth 401(k)

A Roth 401(k) works the opposite of a Traditional 401(k). You fund the account with after-tax dollars, but qualified withdrawals are tax-free. If you suspect your tax rate will be higher later in life, choosing a Roth 401(k) over a Traditional 401(k) may be a good choice. There aren’t any income restrictions and you can roll the money into a Roth IRA at any time (which will prevent you from having to take Required Minimum Distributions (RMDs) later on).

Solo 401(k)

A Solo 401(k) is similar to a Traditional 401(k), but it’s for self-employed workers with no employees. 

Pros of Having a 401(k)

A 401(k) plan has many perks, including:

  • High contribution limits. For 2020, you can contribute up to $19,500 to a 401(k). If you’re at least 50, your limit is $26,000.
  • Employer-matched contributions. Many employers match 401(k) contributions dollar-for-dollar up to a certain percent. If you make $100,000 a year and your employer matches your contributions up to 3 percent, you could contribute $3,000 and your employer would throw in an additional $3,000, bringing your total up to $6,000. 
  • Pre-tax contributions. Making pre-tax contributions has two major benefits: It allows you to save more upfront because you’re not paying taxes and it lowers your adjusted gross income, which lowers your tax bill for the year.

What to Know About a 401(k) Plan

There are a few things to be aware of when contributing to a 401(k):

  • Vesting period. Many employers require you to stay with the company for a set period of time before you own your employer match. For example, if your employer contributes $5,000 to your 401(k) but you’re only 25 percent vested when you leave the company, you get to keep $1,250 of the match. 
  • RMDs. With a 401(k) plan, you’re required to start withdrawing from your 401(k) at age 72. If you don’t, you may have to pay a 50 percent penalty tax on any amount you should’ve taken out.

IRAs

There are many different types of IRAs, but the two most popular ones are a Traditional IRA and a Roth IRA. These aren’t employer-sponsored. You’re required to open these up yourself. 

SEP and SIMPLE IRAs are employer-sponsored and are subject to different rules and contribution limits than Traditional and Roth IRAs. 

Traditional IRA

Traditional IRAs are similar to Traditional 401(k)s. You fund your account with pre-tax money, the earnings grow tax-deferred and you pay tax when you withdraw the money in retirement. For 2020, you can contribute up to $6,000 or $7,000 if you’re at least 50. 

Roth IRA

You pay taxes on Roth IRA contributions upfront. But your money grows tax-free and withdrawals are tax-free. Plus, you’re not required to take minimum distributions when you turn 72 as you are with 401(k)s and other IRAs. 

However, Roth IRAs have income restrictions. For 2020, you qualify for a Roth IRA as long as your modified adjusted gross income is no more than $206,000 if you’re married or $139,000 if you’re single.

SEP IRAs

A Simplified Employee Pension (SEP) IRA is a type of traditional IRA designed for self-employed individuals and small business owners. 

The main benefit of a SEP IRA is its high contribution limit. For 2020, you can save up to $57,000 or 25 percent of your salary, whichever is less. This limit is nearly 10 times higher than the traditional IRA limit. 

However, if you’re a small business owner with several employees, the IRS requires you to contribute the same percentage to your employees’ plans that you do to your own. So, if you contribute 15 percent to your SEP IRA, you must also contribute 15 percent to your employees’ plans. 

It’s wise to discuss your options with a financial advisor

SIMPLE IRAs

A SIMPLE IRA is designed for small business owners with fewer than 100 employees. Unlike 401(k)s that have optional employer matches, SIMPLE IRAs have required matches. 

Your employer may match your contribution dollar-for-dollar, up to 3 percent of your salary. Or your employer may contribute 2 percent regardless of whether you use the plan. 

Aside from the required employer match, SIMPLE IRAs are similar to 401(k)s. They’re funded with pre-tax dollars and you pay taxes on withdrawals in retirement. For 2020, you can contribute up to $13,500 or $16,500 if you’re at least 50. 

401k and IRA Similarities and Differences

There are a lot of similarities and differences between 401ks and IRAs. Use the chart below to view each account type at a glance.

CHART (1)

The Bottom Line

Given the number of retirement options available to you, it can be difficult to know which ones you should use. At Scarborough Capital Management, we’re committed to helping you simplify the retirement planning process. Whether you’re mid-career and need advice on how to invest your 401(k) dollars or you’re near retirement and need to create a tax-efficient withdrawal strategy, we’re here to guide you every step of the way. 

Contact us to see how we can help.

 

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