You've probably heard a lot about 401ks and IRAs. But do you know how they compare to each other? More importantly, how do you know which is better for you?
401ks are usually employer-sponsored retirement accounts. Unfortunately, not everyone has access to those. Meanwhile, anyone can open a Roth IRA or Traditional IRA. To get the most benefits possible, you should max out contributions to both accounts if you're able to.
But maxing out both may not be an option for you. So the real question here is, should you contribute to your IRA or 401k first?
I'll give you two answers, one will be a short "quick version" while the other will be a detailed comparison and contrast analysis via chart below (as in, the actual "Clash of the Titans" you came here for.)
Let's start with the quick and dirty version.
The account you should contribute to first depends heavily on whether your employer offers a 401k with a company match. Scroll to the option that applies to you.
Contribute to your 401k only to the point where your employer will no longer continue matching your contributions. This way, you can get as much free money as possible. Then consider an IRA.
Start with an IRA first. Opening one is free. After contributing up to the limit, contribute to your 401k for the pre tax benefit it offers.
| 401k
|
Traditional IRA | Roth IRA | ||
| contribution limit | $18,500 for those under age 50.
$24,500 for those age 50+. |
$5,500 as a combined IRA limit. $6,500 for those age 50+. | ||
| Pros | Employer contribution match. (If offered.) Higher annual contribution limit. Contributions lower taxable income in the year they are made. Eligibility is not limited by income. Able to borrow up to $50,00 or 50% of your 401k's value, whichever is greater. |
Large investment selection. If deductible, contributions lower taxable income in the year they are made. |
Large investment selection. Qualified withdrawals in retirement are tax free. Contributions can be withdrawn at any time. No required minimum distributions when you retire. |
|
| Cons | No control over plan and investment costs. Limited investment selection. Distributions in retirement are taxed as ordinary income, unless a Roth 401k. Required minimum distributions start at age 70 1/2. |
Contribution limits are lower than a 401k. Deduction phased out at higher incomes if you or your spouse are covered by a workplace retirement account. Distributions in retirement are taxed as ordinary income. Required minimum distributions begin at age 70 1/2. |
Contribution limits are lower than a 401k. No immediate tax benefit for contributing. Ability to contribute is phased out a higher incomes. |
|
| Bottom line | Fund a 401k first if your company is willing to match your contributions. | Fund an IRA first if your 401k doesn't offer a match or if you can't get a 401k.
If you max out your IRA, start funding your 401k. Are you not sure which IRA is best for you? If you plan on being in a higher tax bracket when you retire, choose a Roth. (Yea. I know that isn't the easiest thing in the world to predict.) |
||
Keep reading to read more useful information about IRAs and 401ks, along with the conclusion to this article. Spoiler alert: we are going to discuss a nontraditional option that you might consider--especially if you're a real estate investor.
| 401k | Traditional IRA | Roth IRA | ||
| Tax treatment of contributions | Contributions made with pretax dollars, which reduces your taxable income on a dollar for dollar basis. Some employers offer a Roth 401k option, funded with after tax dollars. Investments in the account grow tax deferred. If Roth 401k, investments grow tax free. |
Contributions are deductible. Higher income and participation in a workplace retirement account (for you or your spouse, if married filing jointly) may reduce or eliminate deduction. Investments in the account grow tax deferred. |
Contributions are not deductible. Investments in the account grow tax free. |
|
| Investment options | Limited choice of investments.
Some plans have a brokerage option with access to investments outside of the plan. |
Any investment available through your account provider (stocks, bonds, mutual funds, etc.). | ||
| Taxes on withdrawals after age 59 ½. | Distributions are taxed as ordinary income. If Roth 401k, distributions are tax free. | Distributions are taxed as ordinary income. | Distributions are tax free as long as the account has been open for at least five years. | |
| Early withdrawal rules before age 59 ½. | Unless you meet an exception, early withdrawals of contributions and earnings are taxed and subject to a 10% penalty. | Unless you meet an exception, early withdrawals of contributions and earnings are taxed and subject to a 10% penalty. | Contributions can be withdrawn at any time without taxes or penalties.
Unless you meet an exception, early withdrawals of earnings may be subject to a 10% penalty and income taxes. |
|
If you've got enough money, max out both. Otherwise, fund your 401k to the point where you max out your employer contributions for the year, then max out your IRA. And if you have a lot of money to invest, consider establishing a Self Directed IRA LLC.
Note: You may also want to check out our related articles:
A Self Directed IRA LLC offers the same benefits as a Traditional or Roth IRA, but with even more investment opportunities available for you to choose from, such as real estate, along with asset and liability protection up to one million dollars.
Fair warning though, a Self Directed IRA LLC requires more involvement on your part and is not intended for passive investors. I'll tell you this though. If you're already investing in real estate with your personal funds, there's no reason for you not to get a Self Directed IRA. If you're considering this option, you may find our previous article on investing in real estate with your Self-Directed IRA LLC helpful.
If you still have questions about IRAs, 401ks, or lesser-known retirement options, feel free to ask them below or contact us.
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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