If you’re saving for retirement, you’ll need to know the difference between a 401k versus IRA. You may even have both types of accounts. While trying to secure your retirement, it’s crucial to know what each account type offers you.
We’re going to discuss a few important details of each:
- What is a 401k?
- How does a 401k work?
- What is an IRA?
- Should I transfer to an IRA?
What is a 401k?
A 401k is an employer-sponsored plan. It’s set up by a business, and you can contribute money to it for your retirement.
What is an IRA?
An IRA is an individual retirement account. Virtually anyone can open this type of account and contribute to it.
Both a 401k and IRA are meant for anyone planning for retirement.
401k Versus IRA
A 401k and IRA have two main types:
- Pre-tax, or “traditional” 401k/IRA
- Tax-free, or “Roth” 401k/IRA
The main difference between pre-tax and tax-free is that contributing pre-tax has tax benefits. However, when you take a withdrawal in the future, you’ll pay taxes on these withdrawals.
With a Roth account, you pay taxes now and don’t have to pay taxes on withdrawals. Roth accounts allow your money to grow tax-free. Many companies are beginning to offer these types of accounts because they’re advantageous, as their money grows without further tax liability.
Let’s say that you have tax-free investments at 20. You can grow your money for 45+ years tax-free.
Funding a 401k vs IRA
When it comes to a 401k or IRA account, a 401k allows you to fund the account a little more than an IRA. An IRA allows you to contribute $6,000 – $7,000 per year. However, a 401k will enable you to put up around $19,500 per year.
Additionally, a 401k may have an employer contribution or an employer match.
If an employer puts money into your account, you may reach $50,000 a year in contributions in a single year.
Rules for a 401k
A 401k is started by an employer, and they choose:
- Which brokerage the account is handled in
- What types of investments are available
Employers make the rules for 401k accounts. It’s crucial to understand that these rules may change or be a bit more specific to the employer. However, the general rules that are followed by most employers include:
- As long as you’re an employee of the company, you cannot move the money from the 401k to an IRA until you’re 59 and a half. At this point, you can do an in-service rollover. You can choose this option to take full control of your investments.
- In-service rollovers keep the 401k account open to allow your employer to keep making contributions on your behalf.
- You do not have to pay taxes when rolling over funds in these accounts because you’re not withdrawing the funds yet.
- If you’re under 59 and a half and you have a 401k from another employer, you can move the money into an IRA.
One thing we hear a lot is that many people think that their employer negotiates better rates for them for their investment accounts. However, this is not the case. Mutual funds, which most people are investing in with their 401k, charge the fees and don’t lower them for employers.
Your employer may have fees, and the company can absorb these fees, but you wouldn’t have these fees with an IRA.
Quick Note on In-Service Rollovers
An in-service rollover is a simple process and not something that you need to be overly concerned about. The rollover is a basic decision that requires:
- Advisor calling the 401k
- Ask the rep for an in-service rollover
- Walk through steps with the rep
- Funds are sent to you directly
- Funds are then deposited into your IRA
You may need to sign a paper every once in a while, and that’s really it. A rollover is straightforward and something that we do all the time.
Rules for an IRA
An IRA is an individual retirement arrangement, which means that as an individual, you’re 100% in control of the account. You can choose what brokerage to open an account with and where you want to invest your money to help it grow.
When you have an IRA, you can invest in:
- Individual stocks
- Mutual funds
You don’t lose any benefits when going to an IRA. Most of our clients opt for an IRA because we’re able to direct their investments.
How an Advisor Can Help You with Your Retirement Plan, Even If You’re Younger than 59 and a Half
For a long time, advisors couldn’t really help people who were younger than 59 and a half with their retirement accounts, aside from taking an advisory role. There are a lot of rules and regulations in place that make this process very difficult, specifically with sharing account usernames and passwords.
Here’s a concept that we’ve been using as an advisor to manage a 401k:
- You set us up with a login
- We monitor and make trade allocations for you
We’re able to take a peek at your 401k and the options available to make allocation changes. We’re not granted the power to change contribution amounts or anything of that sort. These accounts are an overlay of your account that allows financial advisors to make trades on your behalf.
Our clients love the 401k option that allows us to manage a 401k on your behalf.
Moving from a 401k to an IRA is often ideal for clients, but you may find the tax advantages of a 401k to be the better option for you. The tax advantages include being able to deduct contributions from your current year’s taxes, but when your money grows, it will be taxed, which is something to consider.
If you’re trying to secure your retirement and aren’t an expert in retirement planning, we can help. We have a wealth of information available for free on our podcast (sign up here), or you can feel free to schedule a call with us.