401k vs. IRA – Which Is Right For You?
Photo by Charlie Wollborg on Unsplash
In this post, I’m going to break down the differences and similarities between 401ks and IRAs. Then I’m going to talk about things to consider when choosing between them. Here’s how this article is broken down:
- What is a 401k?
- What is an Individual Retirement Account (IRA)
- What are the differences and similarities
- Which is right for me?
What is a 401k (or 403b)?
A 401k plan is a retirement account plan that is provided to you by your employer. Every paycheck, you have the option to automatically put a portion of your paycheck (for example 15 cents for every dollar you earn) into a 401k account. Your employer can also “match” what you put into this account.
For example, if your paycheck is $1000, you can decide to have $100 automatically transferred into your 401k. This would be a 10% contribution. Furthermore, your employer can match, let’s say, 25 cents for every dollar you put in. So, on top of your $100 contribution, your employer will transfer another $25 into your 401k account.
Once your money is inside this 401k account, you can now automatically purchase mutual funds offered by your 401k plan. If you work for a non-profit, this is sometimes called a 403b plan but essentially it’s just the same thing as a 401k. It works just the same.
What is an Individual Retirement Account (IRA)?
Just as the name says, an Individual Retirement account (IRA for short) is a retirement plan that you need to open by yourself. With an IRA you’re responsible for opening it and transferring money into it. Your employer won’t automatically open it for you and money won’t automatically be transferred from your paycheck. You can open one through any number of companies: Fidelity, Vanguard, TD Ameritrade, Charles Schwab, etc. After you put money into it, you can buy stocks, ETFs, mutual funds, or even options. The choices are unlimited in an IRA, whereas in a 401k you’re limited to whatever mutual funds your employer’s plan offers.
What are the differences and similarities?
| 401k | Individual Retirement Account (IRA) | |
| What can I invest in? | Only mutual funds offered by your company’s plan | Any Stocks, bonds, ETFs, Mutual Fund, and even Options |
| What’s the most I can contribute to the account? | $20,500 if you’re under 50 $27,00 if you’re over 50 | $6000 if you’re under 50 $7000 if you’re over 50 |
| Are there penalties if you withdraw before 59 ½ | 10% penalty | 10% penalty |
| Are there exceptions to the penalties? | Some exceptions | Many exceptions such as buying your 1s house, education and medical expenses, etc. |
| Can my employer put money into the account too? | Yes | No |
| Is there a Roth option available? | Yes | Yes |
Which one is right for me?
My recommendation is that we should contribute to both accounts if possible.
If not, I would first max out my IRA since I have way more flexibility in what I can buy and there are many exceptions to the early withdrawal penalty. For example, if I want to buy my first home, I can take money out of my IRA for a down payment. After that, I would calculate how much I need for retirement, and then contribute a minimum of that amount. Check out these articles for more information on how we should contribute: