IRA or 401(k)?

Which Retirement Account Belongs in Your Portfolio?

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You may have heard of IRAs and 401(k)s but which should be part of your financial portfolio? Let’s examine some financial situations that may apply to you and put each to the test.

I’m a Stay-at-Home Parent

Because a 401(k) is an employee-sponsored retirement plan, you must have a job to open a 401(k) plan. There are 2 exceptions to this rule: First, you are self-employed. If you own a business, you are the employer and can set up a solo 401(k) that covers yourself. The plan can also cover your spouse if they earn income from the business.

Second, you have a 401(k) from a previous employer and have continued contributing to the account. The past employer won’t match the contributions anymore but most will allow you to keep the account open.

An IRA also requires earned income. There are a few ways to contribute even if you don’t have a job:

  • Exercising Non-Qualified Stock Options: This counts as taxable income and allows you to open an IRA.
  • Alimony Payments: Taxable as ordinary income.
  • Scholarships and Fellowships: If you receive a W2 form for these, it’s taxable income.
  • Spousal Income: You can make contributions to an IRA based on your spouse’s income if you have little to no income of your own but the contributions cannot exceed the earned income of the working spouse.

I Want Access to the Money Before Retirement

All tax-advantaged retirement accounts are designed for you not to have access to the funds before reaching age 59 ½ except under certain conditions. Assuming you don’t fall into one of those exceptions, the only way to avoid the 10 percent penalty fee along with ordinary income taxes is to take a loan from your 401(k). Your employer will have certain rules if they allow loans.

A similar option is a Roth IRA. Because you pay taxes on the money before you contribute, that money is yours to withdraw whenever you would like without penalties or taxes. As long as you only withdraw the contributions and not the money you make, your withdraws are tax-free. If you withdraw the investment gains before 59 ½, all of the early distribution rules, including the 10 percent penalty, will apply.

My Main Retirement Savings Account

Your main retirement savings account should be a 401(k) because of the investment limits. An IRA has a maximum yearly limit of $5,500 or $6,500 if you’re over the age of 50 for 2018. That’s not enough to create a retirement nest egg.

In 2018, you can contribute as much as $18,500 to a 401(k) or $24,500 if you’re over the age of 50. Although most people won’t contribute the full amount, it allows you to contribute at a level that sets you up to reach your savings goals providing you start early.

I Don’t Want to Pay Taxes When I Withdraw the Funds

Tax treatment upon distribution of funds isn’t a question of which type of retirement account but more of what is available to you. With a Roth IRA you pay taxes when you contribute to the account but not when you later withdraw the funds. Some companies offer a Roth 401(k) as well that works the same way. If they don’t, you can contribute to your 401(k) up to the company match and open a Roth IRA and contribute to that account up to the maximum.

I Want to Invest the Money My Way

If you’re a skilled investor, you probably won’t like that your company 401(k) only gives you a few funds to choose from compared to the almost endless options that come with an IRA. Some companies offer a self-directed option for a portion of their 401(k). In that case, you can invest those funds in nearly anything you would like depending on your plan’s rules.

I Don’t Know Much About Investing

In this case, you’re going to like the 401(k). With a limited number of funds to choose from, the account is relatively easy to set up. Most employers also arrange for an adviser to help employees pick the appropriate funds for their account.

If you don’t have much investing knowledge, take some time to learn the basics. Nobody cares more about your money than you do so you have to make some important decisions about how your money is managed. It’s wise to seek the advice of a financial professional but the ultimate decisions will fall on you.

I Want My Company to Match My Contributions

Employee matching is a key component of a 401(k). The terms of the match depend on the employer but in nearly all cases, matching happens in a 401(k).

Although uncommon, some smaller employers may match contributions to an employer’s personal Roth or Traditional IRA. Because 401(k)s are expensive for an employer to set up, this can be a more cost-effective way but with the low yearly maximum, an employee needs a 401(k) to reach their retirement goals. An IRA alone isn’t enough.

I Want the Account to Roll Over to My Spouse When I Pass Away

Estate planning is a complicated endeavor that often requires the help of an attorney but in most states, your retirement accounts will automatically go to your spouse. However, every financial account asks you to name a beneficiary. Make sure that you’ve done that to avoid any complications. More important is for you and your spouse to understand the tax treatment of the accounts that are rolled over. Most surviving spouses will simply roll it into their own IRA or 401(k) making any owed taxes deferred until they start taking distributions.

Be careful. 401(k)s often don’t come with many options if you were to pass away. In most cases, the funds are paid in one lump sum to your beneficiary. Read and have knowledge of the options available to you but seek help from a qualified professional for all estate planning.

I Have a Lot of Money to Invest

If you will only have 1 account, you need a 401(k) since the maximum yearly contributions are more than three times higher than an IRA. However, for diversification, it might be best to have both an IRA and a 401(k). Higher net worth individuals need the help of a financial adviser invest appropriately while being as tax efficient as possible.

I Don’t Want My Employer to Control the Account

In both cases, the employer has no control over your account. Although a 401(k) is an employee-sponsored plan, you will set up the account through an outside company. If you leave your current employer, the 401(k) goes with you. They won’t match your contributions any longer but the account is yours.

An IRA is an account set up by you and doesn’t involve your company. In rare cases, they may offer to contribute to the IRA but they don’t have control over the account.

It doesn’t matter which kind of retirement account you choose. It’s yours and your employer has no control over the funds.

Which Should I Choose?

Possibly the most important difference between the 2 accounts is the yearly maximums. You cannot create a large enough retirement account with an IRA alone. You need the higher contribution limit of a 401(k) to set yourself and your family up for success. However, an IRA along with a 401(k) creates diversification and more investment options. Having both accounts makes a lot of financial sense.