IRA vs 401(k): Which is better for parents?

When it comes to planning for retirement, two of the most popular options available are Individual Retirement Accounts (IRAs) and 401(k) plans. Both offer unique benefits and have specific rules that can impact your retirement savings strategy. As a parent planning for your future, it's essential to understand the differences between these two retirement accounts, their pros and cons, and how to decide which one is best suited for your financial goals.

What is an IRA?

An Individual Retirement Account or IRA is a type of retirement savings account you can open yourself, independent of your employer. There are several types of IRAs, but the two most common are traditional IRAs and Roth IRAs.

Traditional IRA

• Contributions: Contributions to a traditional IRA are typically tax-deductible if you qualify. If you meet the criteria, you can deduct the amount you contribute from your taxable income for that year. For 2023, the contribution limit is $6,500 per year (or $7,500 if you are 50 or older).

• Taxes: The money in a traditional IRA grows tax-deferred, meaning you won’t pay taxes on the earnings until you withdraw the money.

• Withdrawals: Withdrawals made before age 59½ are subject to a 10% early withdrawal penalty, in addition to being taxed as ordinary income. Unlike a Roth IRA, you can’t keep funds in a traditional IRA forever. Required minimum distributions (RMDs) must begin at age 73.

Roth IRA

• Contributions: Contributions to a Roth IRA are made with after-tax dollars, so you don’t get a tax deduction when you contribute. The contribution limits are the same as for traditional IRAs.

• Taxes: The money in a Roth IRA grows tax-free, and qualified distributions or withdrawals are also tax-free.

• Withdrawals: Funds can be withdrawn at any time, but you might pay an additional 10% tax if you do it before age 59½. However, you may still be able to withdraw from a Roth IRA before 59½ if you meet certain criteria. There are no required minimum distributions for a Roth IRA.

What is a 401(k)?

A 401(k) plan is a retirement savings account you get through an employer. It allows employees to save and invest a portion of their paycheck before taxes are taken out. There are a few different 401(k) options available. These are some of the most common:

Traditional 401(k)

• Contributions: Contributions to a traditional 401(k) are made with pre-tax dollars, reducing your taxable income for the year. For 2023, the contribution limit is $22,500 per year (or $30,000 if you are 50 or older).

• Taxes: The money in a Traditional 401(k) grows tax-deferred, with taxes paid upon withdrawal.

• Withdrawals: Early withdrawals (before age 59½) are subject to a 10% penalty, though there are some exceptions. Required minimum distributions start at retirement or around age 72 with some exceptions. 

Roth 401(k)

• Contributions: Unlike a traditional 401(k), Roth plans are funded with after-tax dollars. 

• Taxes: You pay taxes immediately on the earnings you deduct from your paycheck and put into the Roth 401(k) account.

• Withdrawals: Distributions are tax-free after retirement as long as you meet certain criteria. You may pay a fee if you withdraw before those criteria are met. 

SIMPLE 401(k)

• Contributions: Available to companies with 100 employees or fewer. Contributions are immediately vested and employees can borrow against their funds. SIMPLE 401(k) plans (different from SIMPLE IRAs) are like a stripped-down, less expensive version of traditional 401(k) plans. That’s because qualifying employers are exempt from some of the more complex – and costly – IRA compliance and testing requirements with a traditional 401(k). 

• Taxes: Employees contribute with pre-tax dollars. Contribution limits are also different from a traditional 401(k). 

• Withdrawals: You must be 59½ to withdraw without penalty.

Pros vs cons: IRAs and 401(k)s

Pros of IRAs

• Flexibility: Since you can open an IRA on your own, it offers flexibility as you change jobs or if you’re self-employed.

• Tax benefits: Traditional IRAs let you contribute pre-tax income that can grow tax-deferred. They’re also tax deductible. Roth IRAs let you contribute after-tax money toward your retirement which can grow and be withdrawn tax-free.

Cons of IRAs: 

• Lower contribution limits: IRAs usually have lower contribution limits compared to 401(k)s, meaning you can save more money annually with a 401(k) than an IRA.

• Potential for penalties: Early withdrawals from IRAs before age 59½ may incur a penalty in addition to taxes.

Pros of 401(k)s:

• Higher contribution limits: 401(k)s have higher contribution limits, allowing you to save more money for retirement each year.

• Employer match: Many employers offer a matching contribution, meaning they will contribute to your 401(k) based on the amount you contribute.

Cons of 401(k)s:

• Limited investment options: Unlike IRAs, which allow for a wide range of investments, 401(k)s may have more limited options chosen by your employer.

• Employer involvement: Your employer can change or eliminate the 401(k) plan, and if you leave your job, you may be forced to withdraw the funds or roll them into another retirement account.

Is an IRA or 401k right for me?

The best option for you will depend on your specific financial situation and goals. Some factors to consider include:

• Employer match: If your employer offers a matching contribution, it may be worth maximizing that benefit by contributing to your 401(k). Employer matches are essentially "free money" added to your retirement savings, and not taking full advantage of this benefit means leaving money on the table. Additionally, some employers match a percentage of your contributions as well, so it's important to understand your company's policy to maximize your benefits.

• Tax benefits: Whether you choose a 401(k), IRA, or both, comes down to your tax bracket at the time of contribution and withdrawal. Consider whether a tax deduction now with a Traditional IRA or tax-free withdrawals in retirement with a Roth IRA or 401(k) is more beneficial for you. Traditional IRAs and 401(k)s offer immediate tax benefits because contributions are made with pre-tax dollars, reducing your taxable income for the year. On the other hand, Roth IRAs and Roth 401(k)s are funded with after-tax dollars, which means you don't get an immediate tax break, but your withdrawals in retirement are tax-free.

• Contribution limits: If you're looking to save more for retirement, a 401(k) may allow you to contribute more money each year. For 2023, the contribution limit for a 401(k) is $22,500 for those under 50, with an additional catch-up contribution limit of $7,500 for those 50 and older. It goes up to $23,000 for tax year 2024. In comparison, the contribution limit for IRAs (both traditional and Roth) is $6,500, with a catch-up contribution limit of $1,000. The limit increases to $7,000 in 2024 for both IRA types. 

It can be beneficial to consult with a tax professional, financial advisor, or planner to determine the best strategy for your situation. They can help you understand the tax implications and weigh the pros and cons of each option based on your specific goals and needs.

Can I change my mind later?  

Yes, you can roll over funds from a traditional IRA into a Roth IRA, or vice versa. You can also roll over funds from a traditional 401(k) into a Roth 401(k). However, this may incur taxes and penalties, so it's crucial to understand all the financial implications before making any changes.

Both IRAs and 401(k)s offer valuable retirement saving options. Understanding the differences between these accounts and considering your specific financial goals can help you make an informed decision on which one is right for you. Once you decide, monitor your account regularly and make adjustments as needed to ensure you’re on track to reach your retirement savings goals. Remember, the sooner you start saving, the more time your money has to grow, so don't delay planning for your future!

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This blog post is provided "as is" and should not be relied upon as a substitute for professional advice. Some content in this post may have been created using artificial intelligence; however, every blog post is reviewed by at least two human editors.