IRA vs. 401(k): How to Choose a Retirement Plan

401(k)'s and individual retirement accounts (IRA's) are the most widely used employer-sponsored retirement plans in the U.S. - and have been for years, ever since company pension plans began a slow and steady descent. These retirement plans can be confusing if you've barely started saving for retirement, but they don't have to be. 

401(k) vs. IRA

Both 401(k) and IRA plans allows participants to steer money from their paychecks to invest for retirement, earning tax-deferred interest along the way. You have the option to contribute to both, although traditional 401(k)'s are sponsored by employers, whereas IRA's are filed individually. The main difference between the two is how taxes are treated and how much you are able to contribute.

In terms of plan contributions, both 401(k) and IRA plans differ not only in annual contribution amounts, with 401(k) plans allowing for much more cash contributions, but in other ways, too.

  • IRA plans have income restrictions in place that may not allow an individual to open an IRA.
  • Based on your tax status and your annual income, you may be able to deduct some or all IRA plan contributions. The contributions then start growing in a tax-deferred manner.
  • Contributions to 401(k) plans are made on a pretax dollar basis; i.e., money deducted from a plan participant's paycheck before it's taxed.

So how exactly are 401(k) plans and IRA's similar and how do each differ? Here's a snapshot of each plan:

IRA Plans

IRA's are a great way to make sure your retirement money gets some great breaks from a tax savings standpoint. The primary benefit of a traditional IRA is that you are able to deduct some or all of your contributions to the plan. The other benefit is that you are not taxed until your funds are distributed.

Basically, an IRA is a retirement savings plan that allows assets to grow tax-deferred.

That makes contributing to any kind of IRA a good idea. That's because the earnings in the account grow tax-free until you withdraw them. With a traditional IRA, you may be able to deduct your contributions, too, depending on whether you are single and have an employer-maintained retirement plan, or if you are married and filing a joint return.

A caveat. Cash taken out of a traditional IRA is, by and large, taxable. In fact, it's a good idea to wait until after year-end to take a withdrawal from your IRA. By waiting until after Jan. 1, you can make Uncle Sam wait an extra year before he gets his share.

When you hit age 70 1/2, the IRS mandates that you begin withdrawals from your traditional IRA. But the first mandatory distribution -the one for the year you turn 70 1/2 - can be put off until as late as the following April 1. 

401(k) Plan

A 401(k) plan is an employer-sponsored retirement plan that also helps employees stash away cash for retirement in a tax-deferred manner. With a 401(k) plan, after an employee retires, any withdrawals are taxed by the IRS. 401(k) plans allow career professionals to park a significant amount of cash into their retirement savings, and are taxed at the individual's tax bracket once he or she hits retirement, and starts withdrawing funds. Contribution limits are much higher than IRA's, which allows more robust asset growth in 401(k) plans.

With a 401(k), a big benefit is that the money you contribute reduces your taxable income, plus all the earnings grow tax-free until withdrawal. But the biggest benefit may be in the employee match, where data show that more than 70% of all employers provide matching 401(k) plan investments with about 50 cents on your contribution dollar. That's free money from your employer, going directly into your retirement account.

Contribution Limits for IRA vs. 401(k) Plans

The federal government caps the amount of income you can steer into an IRA or a 401(k) plan, as follows.

IRA contribution limit

According to the Internal Revenue Service, the annual contribution limit to your traditional IRA is $5,500. But if you are 50-years-old or older, the IRA allows you to contribute $6,500 for the tax year.

401(k) plan contribution limit

The contribution limit for 401(k) plans is $18,500 a year, but as with IRA plans, you are allowed a catch-up contribution amount of an extra $6,000 for Americans over 50 years of age. Since 401(k) plans allow for employee matching contribution, the IRS allows 401(k) users to contribute up to $36,500 from employee matching and profit-sharing contributions.

Costs of IRA vs. 401(k) Plans

Like most investment vehicles, both IRA's and 401(k) plans do come with fees, charges and penalties for early plan withdrawals.

Cost-wise, IRA plans are lower than 401(k) plans, even though your mileage may vary depending on what specific 401(k) or IRA plan you choose.

For example, fees vary widely on 401(k) plans, average between 0% and 2% of total plan assets. Your 401(k) plan prospectus will spell out your plan's cost and fee structure - it's worth checking out.

IRA's generally cost less than 401(k) plans, as there is normally less money to manage and IRA's don't come with annual fees. IRA's, even with investment advisory and fund management fees, usually cost investors less than 0.50% of total plan assets, giving them the cost edge over 401(k) plans.

Benefits of 401(k) Plans 

  • Higher contribution limits. At $18,500, plus a company matching contribution that can add more plan contribution dollars, 401(k)'s allow plan participants to pour much more money into their retirement plan.
  • Strong employer contribution matches. Aside from the higher contribution limits, this is truly the Holy Grail of 401(k) plans - the employer match. If you can get one, many employers match up to 50% of your plan contribution, up to a certain cash limit.
  • Protected assets - Not a lot of people seem to realize it, but 401(k) plans are largely protected from creditors.

Weaknesses of 401(k) Plans

  • Higher fees. Given the higher amount of money associated with managing 401(k) plans, fees are higher for 401(k) plans than they are for IRA's.
  • Lack of investment options. While 401(k) plans have come a long way over the years in offering new options like stock brokerage services, access to international funds, and adding low-cost exchange-traded funds, they still lack the investment options that typically come from IRA's.
  • Taxes upon taking withdrawals. Taxes do become an issue once you start taking contributions out of a 401(k) plan. Additionally, there are onerous taxes for taking out early plan withdrawals of up to 20%.

Benefits of IRA Plans

  • Tax advantages. Many IRA's allow plan contributions to be tax deductible from your taxes, even though earnings grow tax-deferred into retirement.
  • More investment options. As IRA's are self-directed, you can knock down the investment options of 401(k) plans and invest in many more investments, including more stocks, funds and fixed-income investments.
  • Easy to start. IRA's aren't very complicated to set up and many self-directed investors do so on their own. That saves both time and money.

Weaknesses of IRA Plans

  • Limits to plan contributions. As annual IRA plan contributions are capped out at $5,500 ($6,500 for Americans aged 50-or-older), IRA's fall well short of 401(k) plans in terms of yearly plan contribution amounts.
  • No contribution match. Another downer for IRA consumers - companies won't be offering any company matches for IRA's, as they do for 401(k) plan participants.
  • Withdrawal penalties. Just like 401(k) plans, early withdrawals from IRA's trigger substantial tax penalties.

How to Pick Between an IRA and 401(k)?

There's much to say in favor of both IRA's and 401(k) plans. Both offer tax-deferred growth and taxation in retirement when you're presumably in a lower tax bracket.

On the cash accumulation side, it's hard to argue against a 401(k) plan. After all, plowing $18,500 or more into a tax-deferred savings account every year is a very good thing for hard-working Americans who deserve a comfortable retirement.

On the account management side, IRA's offer more investment options and more tax advantages (if you meet the IRS IRA tax deduction requirements, and millions of Americans do.) Plus, they're less expensive to run.

In the end, you can have the best of both worlds - and actually have a 401(k) up and running and, in many cases, open up an IRA plan, too. You'll be subject to contribution limits, but you'll also be maximizing your retirement savings on an annual basis, and that's going to work in your favor over time.

Just make sure to contribute as much as possible into your 401(k) plan first, as it allows for higher contributions, and then add as much cash as you're allowed to an IRA.

That's a balanced retirement plan recipe that, once it's up and running, should lead directly to a cash-flush retirement for the savvy long-term investor.

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