Even if you’ve never pursued a retirement plan for you and your business before now, you’ve likely heard about IRAs and 401(k)s. These are the two most common types of retirement plans out there, and for good reason, because they both offer tax advantages to save for your future.
Who Is Allowed to Start an IRA versus a 401(k)?
An IRA can be opened by any individual with earned income, so it’s very accessible for most Americans. By comparison, a 401(k) must be opened by someone who owns a business, and this includes the self-employed as well as companies with employees. So, although a typical worker cannot start their own 401(k), many business owners offer this plan type to their employees due to the added benefits, which of course is why it’s a widely popular retirement plan.
What Are the Biggest Differences Between an IRA and 401(k)?
There are some notable differences between IRAs and 401(k)s. The biggest is that they have very different contribution limits. For example, you can only contribute up to $6,000 to an IRA for the 2021 tax year (or $7,000 if you’re over age 50). On the other hand, an employee participating in a 401(k) plan can contribute up to $19,500 this year (or $26,000 if over age 50). However, that’s not all you can put into a Solo 401(k) plan. You can also make employer contributions. That’s the beauty for the self-employed -- you are both the employee and employer. If you’ve heard of matching or profit sharing in a 401(k) plan, well, that’s what the employer does. As an owner-only businesses, you can contribute up to $58,000 for the 2021 tax year (or $64,500 if over age 50) assuming you have the earnings to do so (there is a calculation –typically 20%-25% of earnings can be contributed as an employer up to the limit). So, as you can see, the 401k plan provides much more saving power over an IRA.
| 401(k) Advantages Over Traditional IRAs in 2021 | 401(k) | IRA |
|---|---|---|
| Annual limit per individual | $58,000 (employee + employer contributions) |
$6,000 |
| Age 50+ catch-up amount | $6,500 | $1,000 |
| Roth income limit | None | $140K* |
| Penalty-free access, if needed | Yes, via a loan | No |
*Beginning at $125K, the amount you are allowed to contribute begins to decrease, hitting $0 at $140K for singles (range is $198K to $208K for married couples filing jointly)
401(k) Offers Penalty-Free Access to Money in Emergency
But wait – as you can see in the chart above – there’s more! Unlike an IRA, the 401(k) plan can include a loan feature, which gives you more flexibility when you need to take funds out of your retirement plan. If you pull funds out of an IRA before age 59 and ½, you’ll typically pay taxes on those funds along with an early withdrawal penalty. However, these penalties can be avoided when taking a loan from a 401(k) plan. The loan feature allows you to request up to half of the assets in your 401(k), not to exceed $50,000, and typically must be repaid within a 5-year period to avoid taxes or penalties. This is typically a pretty automated payback process to your account.
Retire Tax-Free with Roth Savings!
Another feature worth considering is the Roth contribution. You may be aware that an IRA can be opened either as a Traditional IRA or Roth IRA, which determines the tax treatment of your contributions. Traditional IRA contributions are tax-deferred, meaning that you’ll save on taxes for the year you’re contributing and pay taxes when withdrawing your contributions (and earnings) in retirement. In contrast, the Roth IRA has the opposite tax effect. You’ll pay taxes on contributions during the year you’re contributing, but all contributions and earnings can be withdrawn tax-free in retirement (after age 59 and ½). A 401(k) plan can also offer both traditional and Roth contributions with a couple added advantages:
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Roth IRA contributions still have an annual limit of $6,000 as mentioned above, while the 401(k) allows up to $19,500 for the 2021 tax year.
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Depending on your income for the year, your annual contribution to a Roth IRA may be reduced or eliminated; however, this rule does not apply to Roth 401(k) contributions.
Lastly, if you own a business with employees, a 401(k) plan is a great tool to incentivize employees and possibly make retirement contributions of your own. And as a business, plan admin expenses are tax deductible and if you have 1-100 employees you can receive up to $5,000 in tax credits the first three years of starting the first plan for your business.
By now you might be wondering why anyone would start an IRA over a 401(k). First of all, it’s worth mentioning that it’s possible to utilize both plan types when saving for retirement. However, you may be limited to one plan depending on your employment situation or the amount you’re looking to save. If you’re not self-employed or running your own business and your employer doesn’t offer a 401(k), an IRA is likely your best option. Or if you own a business but aren’t looking to save beyond the IRA contribution limit of $6,000 per year, it likely does not make sense to start a 401(k) plan. If these restrictions don’t apply to you, the savings power of the 401(k), along with its added features may make it the perfect fit for your retirement goals!