The other day, I was reading about a startup that wants to change how small businesses set up savings plans for their employees. Much of the discussion was about how they use IRAs instead of 401Ks to make it easier for employers to set up a retirement plan. So I wanted to take a few minutes to talk about 401Ks, and what their pros and cons are relative to an IRA retirement account.
The 401K retirement plan was created in 1978 by the IRS when they defined the guidelines in - you guessed it - section 401(k) of the Internal Revenue Code. A 401K is a retirement plan much like a traditional or Roth IRA, and in particular, it has a lot in common with a traditional IRA.
Similarities between a 401K and an IRA.
The biggest similarity between a 401K and a traditional IRA is that the contributions are tax-deferred, which means that if you put $5,000 into a 401K or a regular IRA in any given year, you won't pay taxes on that $5,000. So, depending on your tax bracket, you could easily save over $1,000 on your taxes since that $5,000 won't be counted as income for that tax year.
The advantage is that deferring taxes allows more money to go into the savings account and be compounded over time. You will, of course, have to pay taxes on the money eventually but by the time you need to make withdrawals you will be retired and likely be in a lower tax bracket, plus the money will have grown over time. However, it's worth noting that a Roth IRA functions differently since you pay taxes on any money that goes into the account, so once you start taking distributions from it, the money that comes out is tax-free since it's already been taxed once.
Another similarity is that earnings on assets inside a 401K or any IRA (Roth or traditional) aren't taxed while they are in that account. This means that if your 401K or IRA holds a bond, you won't pay taxes on the regular coupon payments that come from that bond, whereas in a regular investment account these payments would be taxable as income.
Likewise, a 401K and a traditional IRA have similar penalties for early withdrawal, such that if you take any money out before you're 59 1/2 years old, you pay taxes plus a 10% penalty on any money that comes out. This is a retirement account after all, and the government wants people to remember that. The caveat is that a Roth IRA will let you take out the original principal that was contributed to the account, but you'll pay taxes and penalties for any amount over that.
Lastly, after you turn 70, you'll be required to take a minimum amount of money out of either your 401K or your IRA every year or face some stiff penalties.
If they're so similar, why have a 401K?
There are a few key differences between a 401K and an IRA, but the biggest are probably the organizational and contribution differences. Namely, a 401K is set up by your employer, whereas an IRA is set up by you. And since the 401K is set up by your employer, they often match contributions by employees into their 401Ks. This means that you can put a lot more money into a 401K than an IRA (see our blog post on Is Maxing Out My Roth IRA Enough to Retire On?). As of 2015, an employee can contribute up to $18,000 every year to their 401K, but the total contribution limit between the employer and the employee is $53,000 a year. This means that you, as an employee, can put in $18,000, but if you have a really nice employer, they can not only match your contributions but also give an added top-up to your 401K up to the $53,000 limit.
This makes the 2015 IRA contribution limit of $5,500 ($6,500 if you're over 50) look rather paltry. So if you have a nice employer that provides you with some contribution matching, a 401K can be a lot more attractive than an IRA in terms of setting aside money for retirement. After all, you can always roll your 401K into an IRA, which many people do when they switch jobs or retire.
Another key difference is that there are no income limits for tax deductions for a 401K as opposed to an IRA. It gets a bit convoluted, but if you or your spouse don't have access to a 401K, then there's no difference between the 401K or the traditional IRA. However if either of you have access to a 401K, your tax deductions for your traditional IRA contributions have diminishing returns depending on your annual income. For example, lets say you or your spouse are covered by a 401K at work and you file your taxes together, if your combined income (as of 2014) is more than $116,000 a year, you won't get any deduction on contributions made into your IRA. Whereas, if you made less than $96,000 a year, putting $5,500 into your IRA would allow you to deduct $5,500 from your annual income for tax purposes. You can find more information on IRA deduction limits on the IRS website.
Lastly, you may be able to borrow money from your 401K if your employer allows it, but you won't be able to borrow from your IRA without incurring the penalties for an early distribution. However, it's tricky borrowing from your 401K and it often carries a lot of hidden costs and dangers, as explained in this article by Forbes.
Amongst these differences between a 401K and an IRA, there are also a few disadvantages for a 401K. Arguably the biggest disadvantage is that a 401K is generally more restricted in what it can invest in because it will only have access to investments that have been white-listed by the 401K plan provider and the employer. Meanwhile, an IRA will allow whatever investments the custodian is willing to hold, which could include low-cost ETF or mutual funds that aren't available to a 401K participant.