IRA or 401(k) – What’s the Difference Anyway?

You have to make a lot of decisions as you plan for retirement.

Among those decisions is the choice to use an IRA or 401(k) to save money. Which one should you use, and what’s the difference between them anyway? Can you even do both? Let’s figure that out.

IRA versus 401(k)

If you like analogies, you can say that the difference between an IRA and 401(k) is similar to the difference between driving yourself to work and taking public transportation (the IRA is like driving yourself to work). Either one will get you from point A to point B, but one or the other might be better. Public transportation could be very good or horrendous, depending on where you live, and the quality of your 401(k) depends on where you work.

When you use an IRA, you are in control of everything. In fact, the “I” in IRA stands for individual – it’s an individual retirement account. A 401(k) is a retirement plan that can only be offered by an employer, and your employer makes most of the decisions about what happens with your money.

What are some of the choices that come into play with an IRA or 401(k)?

Investment provider: you can open an IRA wherever you want, using any online brokerage, bank, or financial planner that you want. You can use any type of investment allowed by the IRS (or at least not prohibited). However, your employer typically decides where your 401(k) money will be invested, and most 401(k) plans invest in mutual funds (not that there’s anything wrong with that). Your company might pick a perfectly good investment provider, but sometimes you’re better off doing things on your own.

Fees: because you can open an IRA wherever you want, you can choose to go with low-cost providers, or to pay extra for any services that might be valuable to you. 401(k) plans generally have additional fees built-in, and you might not really benefit from those fees. However, if you work for a large (or especially cost-conscious) company, your fees might be lower in the 401(k) versus IRA accounts available to you.

Of course, one of the most important differences between IRAs and 401(k)s is the ability to get matching money from your employer. Even if your company has less-than-stellar investments and fees, you can still come out ahead by contributing at least enough to get the full company match. After that, an IRA may start to look more attractive than the 401(k).

401(k) and IRA Features

There are some other important differences between IRAs and 401(k) plans which have nothing to do with where and how you decide to invest. IRAs and 401(k)s are designed to provide different incentives, so the rules for each type of account are different.

Note that some of these differences might not apply in your situation – your employer gets to choose whether or not to include certain features in your 401(k) plan. The fewer features you have, the less difference it makes whether you choose IRA or 401(k).

Deductions and income limits: with a 401(k) plan, you can make pre-tax (and possibly after-tax, if your employer allows it) contributions to the plan regardless of your income – if you’re eligible, you’re good. With an IRA, it’s more complicated. Your ability to make pre-tax contributions depends on several factors including your income, and whether or not you participate in your 401(k) (among other things). If you make too much, you can’t contribute to a Roth IRA, but there are no income limits for making Roth 401(k) contributions.

Contribution limits: knowing how much you want to contribute in a year can help you decide whether to use an IRA or 401(k). 401(k) plans allow you to do more (up to $18,000 in 2017 versus $6,000 to an IRA). Along those same lines, the most you can contribute to a Roth IRA is $5,500, but you could contribute your full $18,000 to your Roth 401(k) account if you wanted.

Getting money out: it’s much easier to get money out of an IRA when you need it – in most cases you can just call and ask for the cash. You might have to pay fees, taxes, and tax penalties, but your money is available if you want it. With a 401(k), things are more difficult. Typically you have to stop working at your company, reach a certain age, or meet certain criteria before getting money out (and the paperwork can take longer than you’d like). On the other hand, 401(k) plans might allow loans – for better or worse – but you cannot borrow against your IRA.

Magical ages: there is no real retirement age, but the IRS treats you differently depending on whether you’ve got money in an IRA or a 401(k). With either account, you have to take required minimum distributions (RMDs) of pre-tax money after the age of 70 1/2. However, that doesn’t apply to 401(k) money if you’re still employed (and not an owner of the business). Furthermore, you can take money out of a 401(k) without tax penalties if you quit working after age 55. With an IRA, that changes to age 59 1/2.

Do Both

Now that you know how to compare and contrast IRAs and 401(k)s, you may wonder which one is best. Just choose the one that has the features you need for a successful retirement. Better yet, do both – very few people are going to reach retirement with too much money socked away.

If you want use both an IRA and 401(k), you can make the maximum contribution to each account separately (although your income might affect what kind of contribution you can make to an IRA – after-tax only versus pre-tax or Roth).

So, which one looks best to you, or will you do both?

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