The IRA versus the 401(k) Retirement Account

Lots of folks from different walks of life face the same decision of what to do between work and a personal retirement account. Both work towards building up savings for later years, but they have very different rules and applications. Additionally, the way money can be raised in the two different accounts varies as well. Understanding how they work and how to run them concurrently as well as long-term makes a big impact on how to build up the most for retirement as well as avoid unnecessary taxes.

The IRA

The standard individual retirement account, or IRA, is designed for individuals and consumers. It allows people to save a set amount every year, the maximum balance of deposits being established by the federal government every year. For most individuals, that capped amount is $6,500 for anyone below the age of 50. For those at or older than 50, up to $7,500 can be saved in an IRA annually. IRAs also don’t need to be just cash. They can be converted to certificates of deposit, or IRA accounts can be held in a brokerage with the funds traded on public stocks or mutual funds, or bonds.

The key factor is that the money is in the account until the depositor reaches the allowed retirement age. At that point, the funds can be withdrawn. IRAs come in two forms: traditional IRAs, which are pre-tax monies (i.e. before income tax is applied), and Roth IRAs (post-tax funds). If the funds are pre-tax, then the IRA withdrawal will be taxed at the income tax bracket rate that applies that year of withdrawal. If the funds are after-tax, such as in a Roth IRA, the funds and gains are tax-free on withdrawals. In most cases for traditional IRAs, the funds in any IRA have to start being withdrawn at 73 years of age (April 1 after turning 73 years of age). This is called the required minimum distribution. Roth IRA funds can stay on deposit until one pass, which makes them ideal for passing funds untaxed onto beneficiaries.

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The 401(k)

If employed, a worker will often have an opportunity to invest in a work-related retirement plan. This too allows a person to save for retirement, especially in terms of saving more, redirected from income earned and avoiding taxes at the time. The 401(k) retirement plan is the most common option available for employers, but there are other versions like the 457, for example. In any case, the funds deposited are pre-tax, which means withholding taxes are not applied. This is an advantage as most people are in a higher tax bracket at the time, which means higher taxes. Saving the funds in a 401(k) and then withdrawing later in retirement helps reduce the taxes that apply when a person is earning less.

401(k)s do have limits, just like IRAs. The maximum deposit per year is capped at $22,500. However, being older than 50 years of age, a depositor can put in an additional each year, bringing the total up to $30,000.

401(k)s are typically administered by a third party contracted by the employer. The accounts range from only mutual fund or target-date pool choices to public stock market options. Which one an employee has access to depends on what the employer has chosen for their particular plan package.

401(k)s do not replace an IRA. They can be used simultaneously with an IRA, which maximizes how much a person can save for retirement in a given year. Basically, anyone before the age of 50 could, in theory, save as much as $29,000 between the two annually, all of it being tax-deferred. In addition, the same person could then add a Roth IRA to mix and add more on the after-tax side as well at the same time. Most don’t, but it is technically possible with significant retirement and tax benefits.

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Miscellaneous Benefits

A consumer really shouldn’t think of the two plans as an IRA vs. 401(k) retirement plan comparison. Instead, the better strategy is to deposit in both as much as possible. Then, when finished with a given employer, the worker should roll the 401(k) into the traditional IRA (a full balance is doable without an annual cap), consolidating the two. This keeps the funds tax-deferred until later retirement, while still producing gains inside the IRA long-term. Planning ahead like this helps produce a sizable retirement nest egg when it’s time to relax later on.