Now more than ever, the need for investing in some form of a retirement account is the smart thing to do. However, just saving up some money to invest isn't the most difficult aspect of a retirement fund. It is often deciding the right type of retirement fund that turns out to be the biggest hassle. As this is something that deals with perhaps the most vulnerable part of life where there are no do-overs, making the right choice is critical. The most popular retirement investment options are IRAs and 401(k)s. Let's take a look at what sets these two apart so that you can make the right decision with confidence and assurance.
This is the first and most fundamental difference between the two. All the other characteristics of both these options are based on this. 401(k) is offered by an employer. You have to work for an organization and they will take care of the retirement account. IRA or individual retirement account takes a more hands-on approach to a retirement fund. In this, the employer has nothing to do with the retirement fund and you have to take the help of an investment firm to set up an IRA account. This option does offer more control which also means that you will have to take care of a lot of decisions and will probably incur some additional charges in the form of brokerage fees.
401(k) vs IRA
Technically speaking, one is not better than the other. It all comes down to what you want from your retirement plan. While 401(k) offers a more convenient approach to investing in a retirement fund, IRA gives you more flexibility and control over things like where your money is invested and the investment firm that is used for this. It all boils down to how involved you want to be with your investment fund. If convenience and ease of use are what you are looking for then 401(k) will suit you better but if you want all the choices to be made by you then an IRA account makes more sense.
The tax benefits:
This is where you should be aware of the two different subtypes of IRA accounts. There is the conventional IRA account which in terms of taxation is quite similar to the 401(k) account. In a 401(k) account, there is no upfront tax on any contribution you make. This is known as pre-tax. The tax is levied when disbursements are made from this account at whatever rate is prevalent at that time. Similarly, a traditional IRA won't incur any taxes on contributions, up to a certain value that is set by the IRS. Disbursements will be taxed though. The big issue with investing in these types of accounts is that an unknown variable is inserted into the equation. The future tax rate is something that cannot be predicted with any modicum of accuracy. Tax rates could come down or it could climb up without warning. There is just as much chance of saving some money on the taxes as there is to lose to it.
It is the other form of IRA known as Roth IRA that offers an interesting alternative. It is not pre-tax as the other two options we discussed are which means that there won't be any future tax liability that you have to worry about.
Roth or not?
On the surface, Roth IRA might make a lot of sense but it is not so simple. Tax rates do not exactly correlate to other aspects of the economy and this makes it quite difficult to predict. If you are confident that tax rates will increase in the future then going for a Roth IRA is a no-brainer. The issue with this though is that there are annual limits to how much you can invest in a Roth IRA and this means that it cannot accommodate the entirety of your retirement fund. If on the other hand, you are confident that tax rates will come down then going for a traditional IRA or a 401(k) makes a lot more sense.
Who is eligible for what?
Not all investment options for a retirement fund are created equal and not everything is meant for everyone. Let us start with 401(k). The whole point of this option is to keep it simple and its eligibility criteria are no different. You can avail this method as long as you are employed. Different organizations have different methods of handling the 401(k) of their employees and the finer details will totally depend on your specific employer.
Both types of IRA can be availed by anyone who is under the age of 70.5 years and has some form of an employment or is married to someone who has a source of regular income.
Which one to go for?
401(k) is quite rigid and you will have to follow the rules and guidelines set by your employer. You have limited say in the matter but it also offers fewer hassles. IRA on the other hand by its very nature takes a lot more involvement. In return, you get more fluidity and control over your retirement fund. One is not better than the other. The deciding factor is whose decision making ability you trust more - yours or that of your employer’s.
This is another area where the two types of retirement funds differ a lot. 401(k) investments are capped off at $18,000 per year. Your employer can supplement this with their own contribution which must be equal to or less than your own. An IRA is capped at $5,500 for those below 50 years of age and $6,000 for those above 50.
Does that mean 401(k) is better?
This is not as simple as it might appear at first glance. You do have the ability to invest more with a 401(k) but that is not necessarily a good thing. Since you have no control over how your money is invested, it can provide much lower returns. IRA can be a lot more beneficial as they provide higher returns as you are in charge of where and how your money is invested.
As you might have surmised, there is no single right answer and oftentimes the best approach is to use a combination of all of them.
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