Retirement Investing: IRA Or 401(k)?

How are you preparing for retirement? Should you choose an IRA or 401(k)? Let’s define both:

Individual retirement account (IRA) – An IRA is an account established by an individual to prepare for retirement. You will need to go through a bank or broker to set up an IRA, and the amount you are able to contribute to an IRA is subject to annual limits established by the federal government. You can invest IRA funds in a variety of securities including stocks, bonds, and mutual funds.

Photo by urban data, courtesy of flickr

There are two types of IRAs: traditional and the Roth IRA. A traditional IRA uses pre-tax income. When you begin receiving distributions, you will have to pay taxes on them. You must wait until you are eligible for distributions or you will have to pay early withdrawal penalties.

A Roth IRA is financed with after-tax income. The distributions are tax-free. Early withdrawal penalties do not apply to direct contributions to Roth IRAs since they are funded with after-tax income.

Both traditional and Roth IRAs have contribution limits. There are also income restrictions for Roth IRAs.

401 (k) – A 401(k) is a retirement plan offered by an employer that allows employees to invest pre-tax income. The 401(k) is automatic, and enables you to invest without having the money pass through your hands. You can establish a pattern of investing without missing the money.

Aside from the convenience of the plan, your employer may offer a matching program. For example, for every dollar you invest your employer may contribute 50 cents. Why miss out on free money? 

As with traditional IRAs, early withdrawals will come at a cost. For a 401(k) plan, early is defined as before 59 1/2 years of age. If you retire, you must take distributions no later than the year after you turn 70 1/2. For more on 401(k) withdrawal rules, visit wikipedia.

BTW - For employees of public schools and some non-profits, the retirement plan may be called a “403b.” A government employee retirement plan may be called a “457b.”

Each plan has benefits and drawbacks, the impact of which will depend on your individual circumstances (years until retirement, health, number of dependents, marital status, risk tolerance, pre- and post-retirement tax brackets), but my advice: don’t settle for one when you can have both.

When it comes to retirement, you can never be too prepared.