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IRA vs 401k – Which Is Right For You?

Let’s just answer this question right now: you are going to benefit from having both. Here’s why: if you are able to maximize your contributions and you’re over the age of 50, then you’ll be able to personally contribute over $30,000 to your retirement fund that can be invested this year. That money can grow at a 10% rate potentially, which means adding $3,000 of extra cash to your portfolio each year at minimum. In 10 years, with that average return, you’ll double the initial investment with profits.

Except you won’t just have a static account, will you? In 10 years, with maximized contributions, you’ll have saved $300,000. Put in that 10% return and at the end of year 10, you’ll have an extra $30,000 to put into that account, which is the same amount of your initial investment. That’s why it is never too late to begin saving.

If you’re first getting started, however, and you can’t maximize your contributions, there are some advantages that each retirement plan offers that should be considered. Let’s see if an IRA or a 401k plan [or similar retirement offering, like a 403b] is the right option for you.

Why Should I Choose an IRA Today?

For most people, an IRA is going to be a supplemental retirement plan to their primary 401k. This is because the maximum 2015 contribution to an IRA is $5,500. These caps are indexed to inflation, so every so often the limit goes up by $500. Those aged 50 or above can contribute another $1,000 to their preferred IRA. This means you can only put in a third of the income that you can to a 401k plan, but there are some tax advantages.

Many of those advantages come with a Roth IRA. This type of IRA is funded with post-tax dollars, so the earnings grow tax-free. You don’t have an age limit on contributions either, although the federal budget over the last few years has included a provision to change this to a maximum contribution age of 70.5 [just like a traditional IRA]. When you take money out of a Roth IRA, you don’t pay taxes on it because you’ve already been taxed on before the contribution.

Traditional IRAs aren’t tax-free, but they are tax deferred. You put in pre-tax dollars, often from your paycheck, and this money can be invested into virtually anything. These plans are self-directed, so you control the investment strategy. You can either use a cookie cutter investment plan that uses various funds or you can find stocks, bonds, funds, and other investment items on your own and trade when you want.

Why Should I Choose a 401k Plan?

The 401k plans are usually employer sponsored and is one of the easiest ways to get free money today. You heard that right: free money. Many employees don’t opt to take a 401k plan because they see the reduction of their paycheck as a bad thing. The only problem is that most employers will match contributions to a retirement plan as an optional employee benefit. If you contribute 3% of your income to the retirement plan, which for someone earning $30,000 per year is just $900, then you may receive a percentage match on that amount. If you get a 5% match, for example, then you’d receive $45 for free in this example.

That doesn’t sound like much, but it also means that the more you contribute, the more free cash you can earn. The 401k plan is also tax-advantaged, so you won’t have to worry about paying for your gains until it is time to take a withdrawal. Because contribution levels can be as high as $24,000 if you’re above the age of 50, you’ll have the chance to build some key investments with as much free cash from your employer that you can get.

A 401k plan also has one further advantage: you can take a loan out on the equity that you have. Although you’ll need to pay interest on this amount, it won’t be treated as income unless you fail to make the payments. This will then reduce the amount of the 401k and you’ll pay taxes and a 10% penalty for the early withdrawal. Make the payments and you won’t have this problem at all.

What If You Could Only Choose One Product?

If your income limits you to just one retirement plan, then choose the Roth IRA if your income levels qualify. This is because you can take the money out of this IRA tax-free when you reach retirement age. You can start this IRA with many financial institutions for a small contribution, often $200 or less, and immediately invest that cash to help it grow.

Although you won’t get a tax deduction for Roth IRA contributions, most people with the income level to qualify for this IRA aren’t going to be itemizing their personal deductions anyway. The only exception to this rule would be if you have mortgage interest to claim. This may make a contribution to a traditional IRA a better option if you have short-term tax needs that must be addressed.

The IRA is essentially a tax shelter, but your cash doesn’t just sit there. Very few investment items are excluded from being included in an IRA. There are, in fact, just two primary categories that the IRS says you can’t use retirement funds for as an investment medium.

Collectible items. This means you can’t purchase a certified Picasso with your retirement funds. Artwork, antiques, certain coins, stamps, jewelry, wine, or anything that appreciates value based on tangible property wants or needs are all excluded. Rare gold coins, however, are sometimes an exception to this rule.
Life insurance. You cannot purchase life insurance for yourself or purchase a life insurance policy for someone trying to liquidate their own with retirement funds. All types of life insurance are completely off the table.
This means anything else that would be used for an investment can be used. Some financial institutions may limit the types of investments you may make, however, so it is always good to read through the terms and conditions of the investment products before beginning. The two most common investment exclusions for an IRA are private loans and business equity investments.

Do I Need a Self-Directed IRA?

The average person uses one of six investment options in their IRA: stocks, bonds, ETFs, mutual funds, CDs, or cash in a money market account. If that’s what you want to do, then you won’t need a self-directed IRA. It’s when you want to make an alternative investment, such as into real estate, that you’ll need this type of IRA.

There are some advantages and disadvantages to this process. The fees are usually higher for a self-directed IRA and the asset distribution matrix can be quite complex. You’ll generally need to work with an IRA trustee to make sure that you have the money invested properly and the assets purchased properly secured and maintained by a third party.

That’s right – the law is designed so that people who invest into alternative products through their IRA cannot directly benefit from that purchase. If you purchase a house with your IRA, then you are forbidden from living on that property. If you purchase gold bullion, then you are not allowed to store that gold on your own property.

What’s the Best Piece of Saving Advice?

When it comes to investing, whether in an IRA or a 401k, it is best if you just stick with what you already know. Trying to play the real estate market when you’ve never purchased a home before may not be the best idea. If you haven’t tried investing into stocks and bonds before, then learn about the process before beginning or have someone represent you in this matter.

It’s also important to pay attention to your gut instincts. If you feel like something should be done with your retirement plan, then do it. Most intuition pays off pretty well. Don’t try to make an investment just because the government says it is a legal investment to make. Diversification is a good thing, but smart diversification is a lot better.

As a final piece of advice: pay attention to the fee structures of your retirement plan. If you’re in a 401k, then you’ll be paying an annual maintenance fee and if you make changes to your investment structure, you’ll be paying for those as well. In an IRA, you will pay a broker a fee for every trade that you initiate. In a self-directed IRA, all expenses related to your asset purchases must come from the IRA. If you purchase a rental property and the water heater goes out, the IRA pays for the replacement. You cannot combine funds.

The IRA vs 401k conversation is always ongoing. Use both plans if you can, consider the Roth IRA if you can only take on one retirement plan with your income, and start saving. It’s never too early to begin, but it’s also never too late to get started.