401(k) vs. IRA: Which Retirement Account Should You Choose First?

One of the most important things my father taught me about managing money is investing for retirement. Based on his advice, I opened an IRA at age 19 and have been investing ever since.

When I first started investing, I was eligible for an IRA, but I was in the USAF and we did not have a 401(k) plan. It wasn’t until I was in for about two years that the military had an equivalent plan, the Thrift Savings Plan (TSP).

At that point, I wasn’t earning enough money to fully max out my IRA and contribute to the TSP. I had to decide which investment plan was the best for me. Since I didn’t receive a “company” match to my TSP, I chose to invest in a Roth IRA. (Why choose Roth over Traditional IRA?).

IRA vs 401k – Finding the Best Retirement Plan for You

In my current situation, I have a 401(k) plan with my employer, and I have the option of investing in an IRA plan as well. I face the same question a lot of people face: where should I invest my retirement funds – in a company 401(k) plan, or in an IRA? Let’s take a look at the pros and cons of both accounts, then you can use this information to make the best decision based on your needs.

Employer-Sponsored Retirement Plans, including 401(k) Plans:

There are a variety of employer-sponsored retirement plans, including 401(k), 403b, 457, 401a Plans, and Thrift Savings Plan. For continuity, we will use the term 401(k). Please see the IRS page for more info on related retirement plans.

Company sponsored 401(k) plans are similar to Traditional IRAs as far as taxes go – contributions are invested before taxes are withdrawn, which can lower your adjusted gross income (AGI), giving you a tax break now. The invested money will be taxed when withdrawn at retirement age, and there are stiff penalties for early withdrawal.

There is also the possibility of investing in a Roth 401(k), although not all employers offer this option. The maximum annual 401(k) contribution amount is the same for both traditional and Roth 401k plans.

A distinct benefit in favor of 401(k) plans is a possible company match, which is essentially free money for employees. My current company offers a 401(k) match of up to 1.5% of my pay. It isn’t very much, but it is free money and I take advantage of every penny of it!

Individual Retirement Arrangement, or, IRA:

There are two main types of Individual Retirement Accounts: Traditional and Roth. (I have chosen not to focus on SEP IRAs, SIMPLE IRAs, or other forms of IRAs as they are not applicable to everyone, but all are available with the top online brokerage accounts).

• Traditional IRA: The main benefit of a Traditional IRA is that the money can be fully or partially deductible, depending on your situation. The money is invested before taxes are withdrawn, which can lower your AGI, resulting in an immediate tax break. The invested money will be taxed when withdrawn at retirement age, and there are stiff penalties for early withdrawal (barring certain exceptions).
• Roth IRA: Roth IRAs are not tax-deductible, which means you use post-tax money to fund your account. However, the distributions made during retirement age are tax exempt, which is the main reason people invest in a Roth IRA. As with the Traditional IRA, early withdrawals may incur stiff penalties. However, you can withdraw contributions from your Roth IRA at any time. Learn more about Roth IRA withdrawal rules
• For both IRAs: These are individual investments, meaning there are no company matches. There may be certain tax or eligibility restrictions for Traditional or Roth IRAs based on your income, filing, and marital status. The IRA contribution limits can also vary based on age and other factors.

For the tax year 2016, the maximum contribution across all of your IRA accounts is $5,500. The only exception is if you’re age 50 or older, in which case you can contribute up to $6,500 total in what is known as a “catch up contribution.”

Also remember, the maximum contribution for both the IRA and Roth IRA is for both accounts. You can open both accounts and even contribute to both, but your total contribution is limited to $5,500 (or $6,500 if you’re over 50) for 2016.

Pros and Cons of 401(k) Plans and IRAs

401(k)

The biggest benefit of a company 401(k) plan is the possibility of having your company match a portion of your contributions. Free money is something you shouldn’t pass up, especially when it will likely compound over time.

On the downside, some company 401(k) plans may have a limited selection of funds to choose from or may have higher investment fees than you would have if you invested on your own. Your investment options will be limited to whichever funds are in the company plan, which can be detrimental if your plan consists primarily of funds with high expenses.

If your company-sponsored 401(k) plan has limited options to choose from, you should still contribute enough to get your employer match. After that, you can look for other, less-expensive ways to invest your retirement dollars.

If you’re worried your work-sponsored retirement plan charges higher fees than average, it can also pay off to open a free account with Personal Capital. With Personal Capital’s fee analyzer, you can find out how your retirement account fees compare to the benchmark.

Managing your 401(k)

One problem people have with a 401(k) account is figuring out all the options and selecting investments that work for them. Blooom has created their service to look at your 401(k) with all of its options and find the best investments for your needs. Even better the service is a flat $10 per month to have them do all the trading for you automatically.

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IRA

With IRAs, all investment responsibility lies with the individual. He or she must decide where to invest how much to invest, and which firm to use. This can be overwhelming for some people, but there is always the option of paying someone to manage your funds.

The benefit of controlling your investment is the flexibility of deciding where to invest: funds, stocks, bonds, ETFs, etc. the possibilities are limitless. The other benefits of IRAs include controlling your tax diversification options by investing in a Roth IRA for tax-free withdrawals or investing in a Traditional IRA to lower your AGI and current tax obligations.

Where Should You Invest?

Only one of these types of retirement plans involves the possibility of free money – the company 401(k) plan. If your company offers a match, it is probably in your best interest to invest in a 401(k) plan at least to the point of receiving the maximum company match. It is hard to pass up free money!

After you have put in enough money to get the match, I would consider investing in a Roth IRA if you are eligible. Roth IRAs are beneficial because you will be able to withdraw this money tax-free in retirement. Doing this diversifies your future tax liabilities by having a taxable and non-taxable retirement funds.

In addition, you have the option of withdrawing your Roth IRA contributions at any time. You’ll notice I said contributions and not earnings. If you worry you’ll want access to your retirement funds before you actually retire, being able to access your Roth IRA contributions without a penalty might give you peace of mind.

If you have enough money to invest for the full company match and max your Roth IRA, then you should consider investing more money in your 401(k) plan. This will ensure you maximize your retirement contributions and diversify your tax obligations both now and in retirement.

On a personal level, I max out my IRA at the beginning of the year, using money from my savings account. Then I contribute to my 401(k) via payroll deductions. I contribute enough to get the company match and a little on top of that.
My goal is to increase it until I can max out both my IRA and my 401(k) plans. After that, my follow-up goal is to funnel as much money as possible into my retirement accounts while I am young and able to do so!

401(k) Rules

If you’re serious about saving for retirement in your 401(k), it pays to know the rules that govern how much you can contribute, and when. For 2022, you are able to contribute up to $20,500 to a qualified retirement plan like a 401(k). If you get an employer match, those funds can go above and beyond the $20,500 you are able to contribute on your own. The maximum for employer plus employee contributions is $61,000 ($67,500 with the catch-up contributions).

If you’re over age 50, you can also contribute more in what is known as a “catch up contribution.” For 2022, your catch up contribution allows you to add an additional $6,500 to your 401(k) account.

If you have been slowly saving for retirement so far, this option makes it easier to catch your savings up to where they should be but still get the tax advantages that come with investing extra money on a tax-deferred basis.

Here are some additional 401(k) rules you should know about:

• Generally speaking, you cannot take withdrawals from your 401(k) before age 59 ½ without incurring a penalty.
• 401(k) plans generally force you to begin taking distributions at age 70 ½ whether you are retired or not.
• You can roll your 401(k) into another similar account if you leave your current employer.
• You may qualify for a hardship withdrawal from your 401(k) if you meet certain requirements and face a financial hardship.
• If you take money out of your 401(k) before age 59 ½, you need to pay a 10 percent penalty and taxes on those funds in most cases.

IRA Rules & Contribution Limits

The rules that govern IRAs are different for each type – the traditional IRA and the Roth IRA. Remember though, you can only contribute $6,000 to your IRA accounts each year unless you are over age 50. In that case, you can contribute up to $7,000 across your IRA accounts in what is known as a catch-up contribution.

Tax Year	Contribution Limit Age 49 & Below	Catch-up Contribution Limit Age 50 & Above	Contribution Limit Age 50 & Above
2019 - 2022	$6,000	$1,000	$7,000
2013 - 2018	$5,500	$1,000	$6,500
2008 - 2012	$5,000	$1,000	$6,000
2006 - 2007	$4,000	$1,000	$5,000
2005	$4,000	$500	$4,500
2002 - 2004	$3,000	$500	$3,500

Traditional IRAs

With the traditional IRA, there is no minimum or maximum income that prevents people from contributing. However, your ability to deduct your contributions on your taxes hinges on a few details.

Those details include your income and whether or not you also contribute to a work-sponsored retirement plan like a 401(k). If you don’t have a work-sponsored, tax-deferred retirement plan to contribute to, then you can deduct the full amount no matter what.

If you have access to a work-sponsored plan, on the other hand, your ability to deduct contributions on your taxes starts phasing out. For married couples who participate and file jointly, tax deductibility for a traditional IRA begins phasing out at once they reach a certain MAGI (see table below).

This page on the IRS website explains more about phase-out limits and who they apply to.

2022 Traditional IRA Deduction Limits If Your Filing Status Is...	And Your Modified AGI Is...	Then You Can Take...
Single or Head of Household	$68,000 or less	a full deduction up to the amount of your contribution limit.
	more than $68,000 but less than $78,000	a partial deduction.
	$78,000 or more	no deduction.
Married Filing Jointly or Qualifying Widow(er)	$109,000 or less	a full deduction up to the amount of your contribution limit.
	more than $109,000 but less than $129,000	a partial deduction.
	$129,000 or more	no deduction.
Married Filing Separately	less than $10,000	a partial deduction.
	$10,000 or more	no deduction.
If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the "Single" filing status.

Traditional IRA rules to consider:

• With a traditional IRA, you cannot continue making contributions after age 70 ½ whether you are working or not.
• With a traditional IRA, you are required to take minimum distributions from your account by April 1 of the calendar year following the year you reach age 70 ½.
• You’ll need to pay income taxes on your distributions once you begin taking money out in retirement.

Roth IRAs

While a Roth IRA is similar to a traditional IRA in some ways, it takes a different approach to taxes. With a Roth IRA, your contributions are made with after-tax dollars. As a result, your money grows tax-free and you are not required to pay taxes on your distributions when you begin taking them, either.

Unlike with traditional IRAs, however, there are income guidelines that govern who can contribute to a Roth IRA. At certain income levels, the amount you can contribute to a Roth IRA begins phasing out as well.

2022 Roth IRA Income Limits If Your Filing Status Is...	And Your Modified AGI Is...	Then You Can Contribute...
Married Filing Jointly or Qualifying Widow(er)	$204,000 or less	up to the limit
	more than $204,000 but less than $214,000	a reduced amount
	$214,000 or more	Zero.
Married Filing Separately and You Lived with Your Spouse at Any Time During the Year	less than $10,000	a reduced amount
	$10,000 or more	Zero.
Single, Head of Household, or Married Filing Separately and You Did Not Live with Your Spouse at Any Time During the Year	$129,000 or less	up to the limit
	more than $129,000 but less than $144,000	a reduced amount
	$144,000 or more	Zero.

Here are some additional rules that make Roth IRAs unique in their own right:

• You can withdraw your contributions to a Roth IRA without penalty at any time, but you cannot withdraw your earnings in this manner.
• You can pass your Roth IRA on to your heirs without leaving them with a tax bill.
• You can continue contributing to a Roth IRA after age 70 ½ as long as you earn an income.
• You are not required to take distributions from your Roth IRA at any time – even when you’re over age 70 1/2.

Best Places to Open an IRA

You can open a Roth IRA with most brokerages and all mutual fund companies. These are three of your top options:

Ally Invest – One of the least expensive online brokerages, Ally Invest gives you wide access to investments with minimal trading fees.

Betterment – Betterment is a robo-advisor that will do all the investing for you. You fill out a short survey when you sign up and Betterment takes that information and match it with investments that are in line with your goals and tolerance for risk.

E*Trade – One of the oldest online brokerages, E*Trade is a great option for anyone looking to do the investing for themselves.

You can get an IRA with almost any brokerage account, but be careful to know exactly what fees you are paying.

Final Thoughts

These recommendations are based on common situations. You should always ensure your investment decisions are based on your needs and the amount of risk you are willing to take. The most important thing is to get started and keep investing. Your future is worth it!