Start planning for your retirement today to create a pool of resources to be utilized at later stages. There are different retirement plans that you can choose from and while some are sponsored by employers, others are self-managed. The most popular retirement plans are IRA and 401k. If you are familiar with the plans but are not able to decide which one is better for you, this article is for you. In this article, we are going to discuss the features of both the plans and understand the difference between the two plans. This will help you choose a plan that suits your retirement needs.
In this article, you can find the following:
- Introduction to IRA Plan
- Introduction to 401k Plan
- IRA vs 401k
- Which Plan Should You Choose?
Let’s dive in!
Introduction to IRA Plan
An Individual Retirement Plan, abbreviated as IRA, is an individual savings plan that provides you tax benefits for the savings that you make for your retirement. You can invest in an IRA plan through a broker. There is an annual limit up to which contributions can be made by you. The amounts that you contribute and the earnings on the same are taxed deferred and taxed only upon withdrawal. There are restrictions regarding withdrawal and you incur penalty @ 10% if you withdraw the funds before the age of 59.5 years.
There are different kinds of IRA plans to choose from. However, the most common IRA plans are the Traditional IRA plan and the Roth IRA plan. The key difference between them is the timing of the tax advantage on contributions. In the case of a traditional IRA plan, the contributions are tax-deductible and taxed only upon withdrawal. However, in the case of a Roth IRA plan, the contributions are not tax-deductible and, therefore, tax-free in the future at the time of withdrawal.
Another major difference is that in the case of a Roth IRA plan, an individual can’t make any contributions if the income exceeds a certain prescribed limit, however, there is no such restriction in a traditional IRA plan.
Introduction to 401k Plan
A 401k plan is a type of retirement plan that allows the employees to set aside a portion of their salaries into long-term investments. The employer can also opt to make matching contributions subject to a maximum annual limit. The ultimate balance that accumulates in the fund depends on the contributions made by the employer and the employee as well as the income earned on the investments made.
The plan is a tax-advantaged defined-contribution plan which means that contributions are made both by the employer and the employee into the plan up to a certain permissible annual limit and the contributions and income earned on the investments are not taxed until the funds are withdrawn by the employee usually after retirement. In this plan, the employees are free to choose investments that they want to make out of the options provided by the employer. The investment options can be diverse and may include mutual funds, stocks, bonds, guaranteed investment contracts, and so on. There are restrictions regarding the withdrawal of the funds and withdrawing funds from the plan before the age of 59.5 years can attract a penalty at 10%.
There are different types of 401k plans such as traditional 401k plans, self-directed 401k plans, safe harbor 401k plans, tiered profit-sharing 401k plans, and simple 401k plans. The plans have different features and you must make sure what kind of plan your employer sponsors for its employees.
IRA vs 401k
Both plans are retirement plans that provide tax benefits to its subscribers. However, there are some differences that we have highlighted here to help you understand the plans in detail.
1. Contribution Limit For Employee
The maximum amount that an employee can contribute to the plans annually are defined by the IRA. The limits for the year 2020 are as follows:
|Catch-up limit for employees aged 50 years or more||$1,000||$6,500|
Thus, you can see that the contribution limit for the employee is more in case of a 401k plan. An additional advantage with a 401k plan is that employers can also make contributions in the plan unlike an IRA plan and due to this the overall contribution limit further increases in case of a 401k plan.
2. Contributions by Employers
As discussed earlier, a 401k plan allows the employers to make a matching or otherwise contribution to the plan subject to a maximum annual limit. Policies of making matching contributions can vary employer to employer and that is why you need to understand what contributions your employer makes to the plan. The contributions are made as a certain percentage of the salary amount and the maximum annual contribution limit for the employer under a 401k plan is as follows:
- For employees aged less than 50 years: $57,000
- For employees aged 50 years or more: $63,500
This means that when the combined annual contributions are taken into account, the limit for a 401k plan is about 9 times that of the maximum contribution limit applicable to an IRA plan. It implies that if your employer is making matching contributions into the fund, your earnings get double, and as compared to an IRA plan the permissible contributions are much higher.
3. Costs Associated with Plans
Costs become a significant point of consideration when we need to answer “IRA vs 401k; which one we shall opt”. This is because the costs associated with an IRA plan is less than that of a 401k plan. Thus, you must read the plan documents to understand what all fees and costs are being charged to you.
4. Investment Options
Generally, investment options are limited in the case of 401k plans. On the contrary, since an IRA plan is similar to a normal investment account, there is a wide range of investment options available to you under this plan.
Which Plan Should You Choose?
No matter which one you choose, the goal is to maximize the returns. Your investment strategy shall depend on whether your employer offers matching contributions or not under a 401k plan.
If your employer offers to make matching contributions in a 401k plan it means not only you earn on your contributions but your fund value also gets increased by the contributions that your employer makes. Depending on the contribution policies that your employer offers you, make sure that you make enough contributions to get the maximum contribution from your employer. Suppose your employer places a condition that the company will make 100% of matching contributions up to 5% of your salary, then you should make contributions of 5% of your salary so that you get maximum matching contribution from your employer. The rest amount if you want to invest you can do so in an IRA plan.
Now suppose that your employer doesn’t make matching contributions in the plan, then it is better to first start with a traditional IRA or a Roth IRA plan. This is because you get various investment options under this plan and charges are also less in this plan. Once you have exhausted the maximum contribution limit under the IRA, you can move to the 401k plan and make contributions there. This will help you maximize your returns.
Thus, you can invest in both plans and need not choose one. In this article, we have discussed how you can plan your investments in the two funds and maximize your returns.