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401(k) vs. IRA: The Pros and Cons of Both

401(k) vs. IRA: The Pros and Cons of Both

September 01, 2022

Depending on where you work or if you are self-employed or a business owner, there are many ways to save for retirement, and each savings vehicle has its own considerations. Two of the most popular retirement investment accounts are an individual retirement account (IRA) and an employer-sponsored retirement plan (ESRP), such as a 401(k). 

But between an IRA and an ESRP, which one is best for you? That answer will depend on your unique needs, such as whether or not your company offers an employer match, how much you plan to contribute, and when you are planning to retire.

To simplify the information and help you make the best choice for your particular situation, we’ve narrowed it down to three key differences between these two accounts.

1. Contribution Limits

You want to save as much as possible, right? Well, that might determine which type of account you choose. One major difference between a personal IRA and an ESRP is the contribution limit. For an IRA, you can contribute up to $6,000 per year if you are under the age of 50, or $7,000 per year if you are age 50 or older. (1)

On the other hand, the maximum elective deferrals (the contributions that an employee makes) for 401(k) plans is $20,500 if you are under the age of 50, or $27,000 per year if you are age 50 or older. (2) And that’s just how much you can contribute; anything your employer chooses to match or contribute doesn’t count toward that limit.

That being said, most people don’t completely max out their 401(k) contributions so fully funding a personal IRA can get you most of the way there if you do decide to choose that option. 

Although it is wise to make sure you contribute enough to receive any matching contributions offered by your company through an ESRP, any additional contributions you wish to make can go into either the ESRP (up to its contribution limit) or an IRA (up to its contribution limit), subject to the income limitations described below. The ability to contribute to an ESRP is not restricted by income.

2. Investment Options

IRAs are accounts you open yourself and that allow you to control the investment choices, which means you have quite a few more options (e.g., stocks, bonds, mutual funds, index funds) to choose from compared to what your ESRP offers. Employers select a certain number of investment options to offer and that is all you get. You tend to have more flexibility with where your money is invested with an IRA. With fewer options, you may not have as many low-fee choices as an IRA, so watch out for fees with the various funds your ESRP offers. Many people prefer an ESRP because of the convenience and employer match, but it’s important to read the fine print – restrictions and fees – for each option. 

Depending on your preferences (for the tax impact of your saving choices, detailed below), you might choose to contribute up to the maximum amount annually into a deductible or non-deductible IRA, and/or a Roth IRA (if eligible), and also contribute up to the maximum amount annually to your ESRP, as your savings budget allows. Depending on how advantageous the employer’s match on your contributions, and the available employer-selected options in your ESRP, this could be a wise strategy.

3. Tax Implications

Who wouldn’t want to save money on taxes? How you save your money impacts the tax treatment of those savings, so pay attention to this point.

Some employers allow their employees to choose how to invest their money: in a traditional ESRP or Roth ESRP. Contributions to traditional ESRPs reduce income downward on your tax return for the full amount of your contribution, no matter what your total income or tax filing status is currently. The difference between contributing to a traditional ESRP versus a Roth ESRP account is you are using pre-tax dollars for traditional contributions and post-tax dollars for Roth contributions (no downward reduction to income on your tax return). 

Contributions using pre-tax dollars (to traditional ESRPs and IRAs) allow you to reduce your taxable income in the current year in exchange for being taxed on your withdrawals later, including future growth. Alternatively, if you contribute to a Roth account (ESRP or IRA) using post-tax dollars, all growth and contributions grow tax-free. There is no tax benefit in the current year from Roth contributions.

However, there are other situations where things can get confusing. If you are covered by an ESRP and make more than $78,000 as a single filer or more than $129,000 as a joint filer, you will not be able to claim any deduction for contributing to a traditional IRA. (3) If you are not covered by an ESRP, you can claim a deduction on your contributions to an IRA, but there are a few limitations on income, which you can see on the IRS website. There are no income limitations for individuals making non-deductible contributions to a traditional IRA, however the per-person, per-year contribution limits (as described above) still apply.

Are You Making the Most Out of Your Retirement Savings Accounts?

Your choices will have a long-term effect on your portfolio growth and your ability to reach financial goals and live your ideal retirement lifestyle. And because there are no do-overs when it comes to retirement, it can be nerve-wracking to make your selection. So if you’re unsure about whether or not you’re maximizing your retirement savings options, we can help. Email me at Mike@wealthmatters.com or call (707) 428-5500 to get started.

About Mike

Michael Hathaway is a fiduciary financial advisor at Epsilon Financial Group, Inc., an independent, fee-only wealth management firm. Mike has worked in the finance industry for more than 20 years and brings a wealth of knowledge and experience in sophisticated financial planning to help his clients make sound financial decisions. He is known for caring deeply for his clients’ well-being, being compassionate, and thinking creatively to help clients attain their financial goals. He prioritizes building long-term relationships and takes the time to listen, understand, and explain so that his clients feel confident in their financial plan. Mike is a CERTIFIED FINANCIAL PLANNERTM, Chartered Financial Analyst® (CFA®), and Accredited Investment Fiduciary® (AIF®) professional; he has a bachelor’s degree in cybernetics from UCLA and an MBA in finance and accounting from the University of Virginia. When he’s not working at Epsilon, you can find Mike enjoying anything related to exercise and fitness. He especially loves activities in the great outdoors, such as mountain biking, camping, hiking, and snowshoeing. In the fall of 2016, Mike successfully climbed to the top of Mount Whitney in a single day, the highest peak in the continental United States. To learn more about Mike, connect with him on LinkedIn.

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(1) https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits 

(2) https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits

(3) https://www.irs.gov/retirement-plans/plan-participant-employee/2022-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-covered-by-a-retirement-plan-at-work