401(k) vs. Traditional IRA: What is The Best Retirement Account for You?
By Les Stephen
This is a loaded question because although there is some common ground, they are two entirely different animals. The main difference between the two types of accounts is that a 401K is considered an employee sponsored plan provided by your employer, while Traditional IRA accounts are opened by individuals generally through their broker or even at a bank. If you are wondering which one to choose, I have good news. It is possible that you can have both. There are however certain income limits, so always check with your financial advisor before making any decisions. It would probably be best if we discussed these two styles of accounts separately so we can examine the differences. Also, there are many aspects to these types of accounts and below are just a few of the highlights.
What is a 401k?
A 401k is an employee sponsored plan that is generally offered to its employees as part of their benefit package. Here are a few advantages. A 401k is deducted from your paycheck, so it makes it effortless as a participant. The funds grow on a tax deferred basis. The contributions you make decreases the amount of taxable income that you have to report each year. A majority of companies have some type of matching program to the employee’s contributions. The limits are higher than those allowed in a Traditional IRA.
Although the plans are great, there also some downsides. Most 401k’s have a limited amount of investment choices inside the program itself. Because you have not paid taxes on these funds, they become taxable when they are taken out. There are also penalties if withdrawn before the minimum age set by the government.
What is a Traditional IRA
As pointed out earlier, Traditional IRA’s are opened by individuals usually by their broker or at their bank. One big advantage is that there is a wide variety of investment options available including stocks, mutual funds, ETFs, bonds, CDs, annuities, etc. When one stays under the income limit, the contributions can be deducted from your gross income to help with taxes. The funds also grow on a tax deferred basis.
There are a few downsides to this program also. One of the biggest issues is that the limits are low so it might be tough to get to your retirement goal with only a Traditional IRA. They are also subject to penalties for early withdrawal and are taxable upon distribution.
Below are the current 2020 IRA limits. Remember, they may and often do change from year to year.
Basic limit $6,000 $19,500
Catch-up limit if 50 and older $1,000 $6,500
Total limit for those 50 and older $7,000 $26,000
Not to make things even MORE complicated but there are also ROTH 401k’s and ROTH IRA’s. This is why I continue to recommend that you seek advice from an investment professional because everyone’s situation and investment is different. Hope this helps and thanks for reading.
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Some IRA's have contribution limitations and tax consequences for early withdrawals. For complete details, consult your tax advisor or attorney.Distributions from traditional IRA's and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS tax penalty.
Converting from a traditional IRA to a Roth IRA is a taxable event. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.
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