Often, people have a hard time deciding between investing their retirement funds in a traditional IRA or a 401(k). This is for good reason. The two plans have different benefits and drawbacks, and one may be better suited for you than the other depending on your risk tolerance and your financial goals. A financial advisor can help you decide which is the best plan for you, but first, it's important to understand the difference between these two plans.

If you are saving for retirement, chances are that at some point you will be choosing between a traditional IRA and a 401(k) plan because many companies offer them. Here’s what you need to know about saving for retirement with an IRA vs 401(k).

IRA and 401(k) Defined

IRA Stands for Individual Retirement Account. A traditional IRA is a tax-deferred retirement account. This means contributions you make during your working years do not count towards your ordinary income for the year; instead, it is your distributions that are taxed as ordinary income. A Roth IRA is funded with after-tax dollars, but then principal and earnings are tax-free (if distributions are taken within the guidelines established by the IRS).

The 401(k) is a defined contribution savings plan typically offered as a part of an employer benefits package. Like the IRA, there are both traditional and Roth 401(k) options, though the Roth 401(k) is not always offered as an option. As with the IRA, your contributions to a 401(k) are tax-deductible.

Your employer may offer matching funds for both an IRA and a 401(k). For example, they might match 1% of your salary if you contribute 1% yourself, or they might match 100% of 1% of your salary.

Similarities

· Both IRA's and 401(k)s are retirement savings plans.

· Both have Traditional and Roth options.

· Both allow investors to take penalty-free withdrawals at age 59 ½ or later.

· IRAs and 401(k)s both have a 10% early-withdrawal penalty (in addition to any applicable income taxes).

· Both the IRA and the 401(k) can be invested in a variety of options (stocks, bonds, ETFs, mutual funds, etc.).

· Traditional IRAs and 401(k)s both have Required Minimum Distributions starting at a certain age (as of this writing, the current RMD age is 72). RMDs are calculated based on IRS tables that are updated every few years. The most recent revision of these tables came into effect in 2022 (https://www.irs.gov/pub/irs-tege/uniform_rmd_wksht.pdf). Failure to take RMDs results in the investor having to pay a penalty equal to half of the RMD amount (ouch!).

· Both have "catch-up" provisions starting at age 50. This means that investors can save an additional amount of money per year (see below for more) to fund their retirement at a quicker pace, which typically coincides with their higher income-earning years.

Differences

• The yearly contribution limit for a 401(k), as of 2022, is the lesser of: $20,500 or your yearly salary. The catch-up contribution for those 50 or older allows for an additional $6,500 yearly contribution.
• The yearly contribution limit for an IRA, as of 2022, is the lesser of: $6,000 or your yearly earned income. The catch-up contribution for those 50 or older allows for an additional $1,000 yearly contribution.
• Typically, employers that sponsor 401(k) plans will offer some sort of match to the employee's contributions. Not contributing at least to the match amount is leaving money on the table!
• IRAs are typically self-funded and do not have an employer match.
• 401(k) investment options are limited to the plan provider or record keeper's selection.
• IRA investment options are far greater. An investor can decide where to open (or transfer) an IRA account, and thus invest it however they please within the limitations (if any) of the provider they choose.
• You may contribute to both an IRA and a 401(k) in the same calendar year; however, if you do, your income will determine whether your traditional IRA contributions are fully tax-deductible.

Managing 401k Investments

In a 401(k), you're limited to the investment options your employer offers. In most cases, those investment options are managed by a record keeper—a third-party company with investments available for purchase—or by your employer directly.

In order to manage your 401k investments, you'll need to work with either your employer or a record keeper to make sure your automatic contributions are going where you want them.

You may also want to consult a fee-only financial planner, if possible, who can help set up a sound investment strategy for you under the circumstances.

Which One is Right for Me?

First, determine what your financial goals are. Work with an independent fiduciary advisor to work through a series of questions, such as: When do you want to retire? What is your annual “retirement income” goal? What other sources of income will you have in retirement?

Once you know where you are and you have an idea of where you are going, you can map the road to get there by establishing a plan to accomplish these goals.

If your employer offers any sort of match to your contributions, it is generally wise to contribute at least enough to receive the full match. Beyond that, you should follow two criteria to decide if you contribute more: (1) how much will you need to save to achieve your goals, and (2) what are the investment options (or lack thereof) within the 401(k)? These questions will be your guide to determining whether to contribute more within the 401(k) plan or contribute instead to an IRA (keeping in mind the income limits and phaseouts mentioned above).

Conclusion

Nowadays, it’s more important than ever to save for retirement. But if you’re not sure about which type of retirement account is best for you, or how to best utilize a combined strategy, I invite you to reach out to me or any of my colleagues at Fiat Wealth Management to find some answers on a complimentary basis through individual case analysis.

For more information on retirement planning, contact us!

Investment advisory services are offered through Foundations Investment Advisors, LLC an SEC-registered investment adviser.