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Choosing the right plan for your future

401(k)s and IRAs – What Should I Do?

Have you been thinking about the future and want to start investing for your retirement, but aren't sure where to begin? Have you heard terms like 401(k)s, IRAs, traditional accounts, Roth accounts, and have no idea what people are talking about? Don't worry about it; it is much easier than it appears. Here we are going to talk about the differences between 401(k)s and IRAs, what you should consider before investing, and which option is right for you.

Note: This article contains affiliate links. This means that if you purchase a product or sign up for a company through one of our links, Thrive Oak will make a small commission (at no extra cost to you).

Choosing the right plan for your future

Quick Summary Before We Dive In

Keep in mind that 401(k)s and IRAs are just specific types of investment accounts. That is, you can transfer money from one of your bank accounts to a different bank account at an investing firm such as Vanguard. Vanguard then lets you purchase investments (such as stocks or bonds) with the money in your bank account. It’s nothing too complicated. 

401(k)s and IRAs are really just fancy types of investment bank accounts that allow your money to potentially grow faster through two methods. First, 401(k)s are accounts offered by many employers that can include ‘matching’ benefits. That is, the company will pay you extra money to your retirement account if you ALSO contribute to your retirement account.

Second, 401(k)s and IRAs offer unique tax benefits that can allow you to grow money without paying taxes upfront OR without paying taxes on your retirement fund (even on the money that grew tax-free!) when you withdraw your money. 

Of course, you can always invest money outside of these types of accounts, but in many cases we recommend that our readers maximize their employer matching benefits and invest up to 50% of their total retirement savings contributions into either of these two tax-advantaged accounts.  

The rest of this article will explain these concepts in more detail.

What is a 401(k)?

A 401(k) is a tax-advantaged retirement account (an account where your money grows faster) offered by many employers to their employees. You can choose to have a chunk of your salary taken out of your paycheck each pay period to contribute to your retirement plan automatically. By doing so, many companies will also add money to your account, called a contribution match (essentially free money). This money is then put into a variety of investment strategies (options offered by the company) to grow your wealth. Once you retire, you can take this money back out and use it to happily live out your non-working days.

(If you would like to learn more about 401(k)s, click HERE

What is an IRA?

An IRA is an Individual Retirement Account. Just like with a 401(k), the money goes into a tax-advantaged account that helps people build long-term savings for when they retire. When using an IRA, you are just making a retirement fund outside of your job. It is better than just a regular old investment account because you get that special tax-advantage, which will make you more than a regular account ever could! 

(If you would like to learn more about IRAs, click HERE

Traditional vs. Roth

In both 401(k)s and IRAs, you have the choice between the “traditional” option and the “Roth” option. Traditional and Roth options share many similarities, with the main difference being when you pay your taxes. In the traditional choice, you pay your taxes when you pull the funds back out in retirement, which means that you pay fewer taxes now. Whereas, with the Roth option, you pay taxes now and don’t have to pay them when you pull funds out during retirement. 

While there are other small details that you should consider when choosing between the options, the tax time is the main factor that influences most people's choices.

For an explanation on Pre-tax vs. After-tax, read more here.

401(k)s or IRAs – Where Should I Invest?

Trick question! You should invest in both! However, if you don’t have the funds or ability to contribute to both, here is what you should consider:

Job Status

The main question here is, “Do you have a job that offers a 401(k)?” If the answer is no, then your decision is pretty easy because that only leaves an IRA. If the answer is yes, then absolutely do your best to contribute enough to maximize the match that your employer offers to take full advantage of the free money they’re providing to help your retirement fund grow even faster. 

Money

Contribution Amount

As of 2020, contributions in both account types rose. In 401(k)s, you can contribute up to $19,500 per year. Add in your employer matching your contributions, and the maximum amount you and your employer can contribute combined is $57,000! Wow, that is a lot! If you are over age 50, you can add an additional $6,500 to the maximum contribution. 

The maximum amount you can invest in an IRA is much lower. Its maximum contribution is $6,000 per year. If you are over age 50, the maximum is $7,000 annually.

Options

The downside to having a 401(k) is that your options are limited to what your company offers. You can choose from what they provide, and that's it, nothing more. With an IRA, you get to choose whatever you want. You are in full control of your retirement plan, which is a bonus for many.

Eligibility 

Which one can you even get? Great question! 401(k)s have no eligibility limits; you simply have to work at a company that offers the program. Some companies do not provide 401(k)s, and some only offer traditional 401(k)s. For IRAs, anyone can contribute to a traditional IRA. However, there are income limits for Roth IRAs. If you make over $122,000 as a single person, the contribution amount allowed lowers, which means that you may not be able to contribute as much as someone earning less than you.

Withdrawal 

One of the last differences between 401(k)s and IRAs is their withdrawal policies, and it has more to do with if it is a traditional account or a Roth account (what we talked about above). In traditional 401(k)s and traditional IRAs, you can begin withdrawing money from the account at age 59 ½. You also MUST begin withdrawing money before you are 70 ½, whether you need the money or not. If you were to want to withdraw money before you were 59 ½, though, you would pay a 10% penalty on ALL of the withdrawal. OUCH! This is not recommended unless absolutely necessary.

Now, let's look at the Roth version. In both Roth 401(k)s and Roth IRAs, you can begin withdrawing at age 59 ½. Here is a slight difference! In Roth 401(k)s, just like the traditional accounts, you have to start withdrawing at age 70 ½, but with Roth IRAs, you don't have a mandatory withdrawal age. You can withdraw at 70, 80, 90, or whatever! Next, in both Roth 401(k)s and Roth IRAS, if you were to want to withdraw early (before age 59 ½), you could have a 10% penalty on EARNINGS ONLY. Unlike traditional accounts, you can withdraw your personal contributions whenever you want with no fee; you only have to pay penalties if you remove the earnings of your account.

Wow! That was a lot of info, which may have been a bit confusing. Here is a graph to breakdown what we just said! 

FeaturesTraditional 401(k)Roth 401(k)Traditional IRARoth IRA
Offered Through JobSometimesSometimesNoNo
Contribution Limit$19,500($26,00 if over 50)$19,500($26,00 if over 50)$6,000($7,000 if over 50)$6,000($7,000 if over 50)
Contribution MatchAvailableAvailableNo No
Lower Taxes TodayYesNoYes No
Lower Taxes in RetirementNoYesNo Yes
OptionsLimited to CompanyLimited to CompanyAll availableAll available
Income LimitsNo No Yes Yes
Required Distribution MinimumYesYesYesNo
EligibilityAnyoneAnyone AnyoneRestrictions based on income
Penalties10% on all withdrawals before age 59 ½(with exceptions)10% on withdrawals of earnings before age 59 ½ (with exceptions)10% on all withdrawals before age 59 ½ 10% on withdrawals of earnings before age 59 ½ (with exceptions)
Mandatory Withdrawal AgeBy age 70 ½ By age 70 ½ By age 70 ½ None

What We Suggest

Obviously, everyone is different. You should do extensive research and think thoroughly about your life plans and goals before making a choice. BUT, we do want to throw in our two cents. 

Let's imagine a hypothetical with our favorite imaginary helper, Jill Oaks. Jill Oaks has access and is eligible for both a 401(k) and an IRA. Her job offers contribution matches, she isn't picky about what her investment options are, and she doesn't plan on pulling anything out before retirement. This is what we suggest for Jill to do to get the biggest bang for your buck. 

Calculating 401(k) vs IRA

1. Max out your 401(k)

We suggest that Jill begins by maxing out her company 401(k), whether it is a traditional or a Roth. This is because she gets free money! She should contribute until she hits the maximum contribution limit that her company continues to match. If Jill can do that, and she still have time and money left over, she would move on to step #2!

2. Contribute to your IRA

After maxing out her 401(k), Jill would do her best to contribute to her IRA as well. We suggest having the opposite plan type here. So, if you have a traditional 401(k) with your job, have a Roth IRA. OR if you have a Roth 401(k) with your job, have a traditional IRA. Get it? This will allow you, and Jill, to get the best of both worlds with the most savings possible. 

You may be thinking, shouldn’t I max this out as well? The answer is yes and no. If you can max out your IRA as well, that would be awesome; however, it is not always the optimal choice. Remember way back at the beginning of the article when we said that people should “invest up to 50% of their total retirement savings contributions into either of these two tax-advantaged accounts”? This is where that comes to play. If also maxing out your IRA is included in that 50%, then go you! But, if you have already dedicated 50% of your retirement savings to your 401(k), then aim for just a small contribution to your IRA. That other 50% of your retirement savings need to be invested outside of these two accounts to make a well-rounded portfolio. 

3. Go back to your 401(k)

If Jill can max out her 401(k) and her IRA within that 50% budget, then massive props to her! (AND YOU!) Way to be a freaking rock star! If she did that, and she STILL has time and money left over, what should she do? Remember, 50% of her retirement savings should go in either her 401(k) or her IRA. If she still have money left in that 50%, she would go back to her 401(k) to invest in until she reaches that cap. Since her 401(k) is a much larger fund, the compound interest is going to grow much faster than what she would get with an IRA. 

Planting a garden

Got it? Awesome! Good job!

401(k)s or IRAs – Begin Somewhere

The most important thing to remember is to get started as soon as possible. Don't wait to invest in your retirement plan! Why? COMPOUND INTEREST! The longer you have the account (whichever one you end up choosing), the more compound interest you will build. Get started today by reaching out to your company, speaking to a local brokerage, or download an investment app! Once it is set up, it is super simple to stay on the path to becoming a millionaire! 

We greatly hope that this article helped clear up some of your questions on whether you should invest in a 401(k) or an IRA. If you have more questions, please hit us up in the comments or email us with your questions. We would love to help you out!