But just like that grad school exam, your future depends on it.
401ks are confusing—even to someone who’s been writing about them for years—so we’re going to start simple by answer the question: Should I contribute to a 401k or an IRA?
We’ll look at the pros and cons of a 401k or other retirement account at work versus an IRA that is a self-directed retirement account.
Why don’t we save for retirement?
At work or on your own, everybody should save something for retirement. According to a recent survey, 55 percent of Gen Y have not started saving for retirement. No surprise. But we need to start. Look at the reasons people give for not contributing to their 401k:
Yes, we acknowledge that it’s hard to set aside even $50 a month when Two-Buck Chuck is your go-to drink and your iPhone is still on your parent’s family plan. But even if you save less than that, at least it’s something.
Others are confused or intimidated by investing. There seem to so many questions, like our “should I use a 401k or IRA?” question, or “what mutual funds should I invest in?”
Setting aside these for a minute, what’s important is to:
- Automatically save something—even a tiny bit—in a retirement account.
- Invest that money in stocks or bonds (in other words—don’t create an IRA comprised of cash in certificates of deposit.)
Are there exceptions?
Only one: When you’re in credit card debt and paying interest over 10 percent. Even then, I wouldn’t fault someone for contributing a small amount to a 401k.
Now that we have that out of the way, let’s look at the differences between 401ks and IRAs.
401ks vs. IRAs At-a-Glance
|Employer-sponsored account||Individual account
|Annual contribution limit: $19,000*||Annual contribution limit: $5,500*|
|No income limits||Income limits may apply|
|Investment options may be limited by plan||No limit on investment options|
|Can rarely be cashed out penalty-free except in retirement||Can sometimes be cashed out penalty-free|
*For 2019; savers over age 59 ½ are eligible to make additional catch-up contributions.
401ks have limited investment options, IRAs can be diverse
With an IRA, you can invest in virtually anything. You can have an IRA that simply holds a savings account or an IRA with 100 different stocks, bonds, ETFs, and mutual funds.
With a 401k, this usually isn’t the case. Your employer partners with a financial services company to administer your plan. That company then gives you a limited number of investment options (usually, but not always, these are mutual funds).
If you work at a large company you may have a lot of investment choices. If you work for a very small company, however, you may only have 10.
For most people, having fewer investment choices is actually a good thing. Most people aren’t stock pickers and shouldn’t try to be architects of the perfect portfolio with hundreds of mutual funds.
The problem, arises, however, when 401k plans only you can research how your 401k stacks up in terms of investment choices and fees at Brightscope.
401ks have higher contribution limits than IRAs
The whole point of 401ks and IRAs is that Uncle Sam is giving you a break on your taxes to encourage you to save for your retirement. Unfortunately, there’s a limit to this particular generosity.
In 2017, savers under 591/2 can contribute up to $18,00 to a 401k and up to $5,500 to an IRA. (For IRAs, this is an oversimplification, but bear with me.)
When you’re starting out, contribution limits are hilarious. There’s no way you’re going to come close to them. But as you earn more money, pay off debt, and get serious about saving for retirement, it’s another story.
Especially if you’re saving in an IRA alone, $5,500 may not be enough to fund the kind of retirement you’re dreaming about.
401ks let you contribute pre-tax dollars
Normally, if you earn $500 and want to invest it in McDonald’s stock, you first have to pay income taxes on it. So you pay $100 of taxes and invest $400 in a stock. Assuming you hold this stock for many years, when you sell it, you’ll need to pay taxes on the amount the stock has appreciated…called capital gains tax.
Now let’s say you invest the same $500 amount in a 401k. With a traditional 401k, you don’t have to pay income taxes on money you put in. So you earn $500 and can invest $500.
Here’s another example
401ks and IRAs have early withdrawal penalties
Here’s the thing about retirement accounts: They’re meant for retirement.
That means there are early withdrawal penalty.
If you withdraw cash from a traditional 401k or IRA before you turn 591/2, you will owe a 10 percent penalty to the IRS on top of ordinary income taxes.
IRAs provide a bit more flexibility in this arena, and there are a number of exceptions to the IRA early withdrawal penalty. You can, for example, use funds to cover higher education expenses and up to $10,000 towards the purchase of your first app德扑圈官方网址home.
With a 401k, you must prove severe financial hardship to obtain an exemption from the early withdrawal penalty.
Some employers, however, allow you to take out a 401k loan. Essentially, you borrow money from yourself. Although this sounds like a great idea, it’s a slippery slope. Any money you borrow ceases to earn returns for you and, if you lose your job, you must repay the entire loan or pay income taxes and the 10 percent penalty on the outstanding balance.
The decision to invest in a 401k, IRA, is different for everybody and depends on another set of circumstances:
For those eligible, 401ks are the easiest way to save for retirement. The limited investment choices can be a good thing because it simplifies your investment decisions, and the money is automatically taken out of your paycheck.
Some employers even match some or all of your 401k contributions up to a certain limit. So if your employer offers a 401k plan and you’re eligible, you should contribute to it. If they offer a plan with matching contributions and you don’t take advantage, you’re passing up free money!
If you don’t have access to a 401k—or maxed one out—-and still want to save for retirement, you should open an IRA.
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