401k vs IRA: What’s the Difference?

With private sector defined benefit pension plans almost non-existent in today’s workplace, defined contribution plans have become the standard for retirement savings.  Since 1979, when 38% percent of private-sector workers participated in a defined benefit plan (either as the only option or combined with a defined contribution plan), the participation rates have declined substantially while the participation rates in defined contribution plans have risen (See Figure 1 Below).  This trend has shifted the burden of retirement saving from the employer to the employee.

DB-DC Trends 2011 Fig1(Source: Employee Benefit Research Institute)

So, what does this tell us?  It says that we are now responsible for our own retirement.  And the best way to prepare is to take advantage of two types of retirement accounts: the Individual Retirement Account (IRA) and the 401k.  Both types of accounts are geared towards retirement and offer tax advantages as long as you don’t withdraw the funds before age 59 1/2 (you can withdraw the funds but you may owe taxes and penalties on the withdrawals).

But which one of these is the best choice.  Well that, like most things personal finance, may depend on a person’s individual circumstances.  Today, I want to talk about some of the differences between the two to help figure out which one is the best choice. 

401k

A 401k is a defined contribution plan that is sponsored through an individual’s employer; meaning that without an employer, someone can’t contribute to a 401k.  Unfortunately, that means the employer controls the plan and what investments are available to choose from.  So if the only investments in the plan are high fee mutual funds, the employee is stuck with high fee mutual funds. Another potential downfall is that the employer may only offer a traditional 401k (funded with pre-tax dollars) and not a Roth (funded with post-tax dollars) version.  Obviously, this is only a downfall if someone is interested in investing in a Roth 401k.  However, this disadvantage is beginning to disappear as more and more 401k plans are offering Roth.

Of course, there are advantages to these types of plans.  Potentially the biggest advantage of a 401k, is if the employer matches employee contributions up to a certain percentage.  Say my employer matches up to 5% and I contribute to that point, I am making a 100% return on my investment before the money is even put to work in my account.  There isn’t an easier return out there then contributing up to the employer match!  Always take advantage of an employer match, otherwise you are passing up free money!

There are also advantages in relation to the amount that can be contributed per year.  If a person wants to maximize their retirement contributions to the maximum, a 401k offers higher contribution limits compared to an IRA.  For tax year 2014, a person is able to contribute $17,500 into a 401k ($23,000 if the person is 50 or older) while with an IRA, a person is only able to contribute $5,500 ($6,500 if the person is 50 or older).  So if someone wants to put away more than $5,500 in a year, they will either need to go with a 401k or do a combination between an IRA and 401k.

Finally, with a 401k, it is incredibly easy to automate contributions as it becomes a simple deduction off a person’s paycheck.  This is one of the ideas behind why I contribute to my 401k because it is impossible to spend money if it doesn’t make it to you.  I am not responsible for transferring the money from my bank account to my 401k so I know I can’t change my mind and use the money elsewhere.  It forces me to contribute since I would actively have to go and decrease my contribution percentages to be able to get that portion of my paycheck.  Gotta pay yourself first, right?

IRA

Like a 401k, an IRA is a defined contribution plan.  However, unlike a 401k, the individual is in-charge of the account.  An individual can set up an account at a brokerage and invest in a larger variety of options.  But as stated above, a disadvantage to this type of account is that you aren’t able to contribute as much per year.  Also, with an IRA a person is unable to take a loan against the account, which can be done with a 401k.  However, if the IRA is a Roth IRA (funded with after-tax money), an individual does have the option to withdraw their contributions tax and penalty free since those dollars were taxed before being contributed.

So what are the advantages to an IRA?  Well as I touched upon earlier, the flexibility an individual has regarding investments is very much superior to a 401k.  Contributions can be put into a variety of investments, such as index funds, mutual funds, individual stocks, and bonds.  Due to this freedom, IRAs can be a cheaper option since an individiual isn’t locked into potentially more expesive options that an employer plan may restrict them to.

Another benefit, is if a person doesn’t like something about the company their IRA is with, they can move the account.  Don’t like the account with Company X, well roll it over to Company Y.  If a person doesn’t like the options and the company their current 401k is through, they need to complain to their HR department because there isn’t anything they can do.  Once again, an IRA offers more flexibility. 

Taking it Home

So how do you choose which one to use?  Personally, I’ve been exclusively using my 401k while I have been paying off debt.  It is more convenient for me to have my contribution taken straight from my paycheck as I can’t spend it if it never hits my bank account.  I am also lucky that when I joined the company, they were currently overhauling their investment choices and came away offering quite a few low expense options, such as a variety of index funds.  I do have some old, more expensive 401k plans from prior positions that I will be exploring rolling over within the next couple months.  As I am learning is the case with most things personal finance, there isn’t one correct answer one correct answer in regards to which retirement account is the best.  The best option out there for someone all depends on what they have going on.

Which type of retirement accounts do you use? IRA, 401k, or both?  What are your reasons for choosing your option?

*Part of Financially Savvy Saturdays on Femme Frugality and A Disease Called Debt*