There are an abundance of choices available for people looking to save for retirement. However, the 401(k) plan and the Individual Retirement Account (IRA) are the two most common. Both are solid choices, and there is some overlap in how they work and the rules investors must follow to use them properly.
However, there are some distinct differences between a 401(k) and a traditional IRA, and three of those differences make the 401(k) the optimal choice (in my humble opinion) for most people.
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Your investing success ultimately depends on three variables: how much you invest, how fast it grows, and how long you can allow your portfolio to grow.
When you contribute to a 401(k) or IRA, the income taxes you owe on that money are deferred until you retire it. The IRS limits how much you can put into these plans each year, so people can only reduce their taxable income by a certain amount in a given year.
Arguably the main advantage of a 401(k) plan over the IRA is that you can contribute much more to it.
In 2024, individuals can contribute a maximum of $23,000 to their 401(k), which will increase to $23,500 in 2025. For IRAs, individuals can only contribute a maximum of $7,000, which will not increase in 2025.
But the gap is much wider than it seems. Many employer 401(k) plans offer a 401(k) match to help employees save. The IRS leaves plenty of room to use these additional funds. The total contribution limit for individuals in 2024 is a whopping $69,000.
But wait, there’s more — and older workers will appreciate it. Once you turn 50, you’re allowed to contribute another $7,500, and starting in 2025, this “catch-up” will increase to $11,250 for people ages 60, 61, 62, and 63. Meanwhile, the IRA allows an additional $1,000 in annual contributions for those over 50.
As mentioned above, many employers offer to match a portion of your contributions to their 401(k) plans to encourage people to save for retirement. For every dollar you set aside, they contribute on a dollar-for-dollar basis or a stated fraction, up to a certain portion of your salary or a fixed maximum. A typical match is dollar-for-dollar up to 3%. So if you earn $100,000 and send 3% of your salary to your 401(k), your annual contributions total $6,000 – $3,000 from you and $3,000 from your employer.
This money typically comes with no strings attached, other than a vesting period to encourage employees to stay with the company. A company match is an easy way to grow your overall savings, and as a benefit it’s unique to 401(k) plans.
One argument I often hear in favor of IRAs is the flexibility they offer. With an IRA, you have a wide range of options in which to invest your money, including individual stocks. In contrast, investment choices in most 401(k) plans are often limited to mutual funds. Some have started offering exchange-traded funds (ETFs), but generally you can’t buy individual stocks in a 401(k). (The exception is your employer’s stock. Many companies make their matches in their own stock.)
But I think this is a feature and not a bug. There’s nothing wrong with owning individual stocks, but even the best instruments can harm you if misused. Correctly building and managing a portfolio of individual stocks takes quite a bit of time and effort. You should make sure you stay informed about the companies you own, and it’s wise to diversify your portfolio to spread your risk. It’s a lot less work if you own mutual funds and ETFs, and they have diversification built into them. The simplicity of 401(k) plans is a guardrail that can help people avoid going off the rails with their investments.
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I Definitely Prefer a 401(k) Over an IRA for Retirement Savings: Here’s Why Originally published by The Motley Fool
