I Absolutely Prefer a 401(k) to an IRA for Retirement Savings. Here's Why.
I’m here to flex the 401(k)’s wealth-building muscles.
Most people spend their lives working toward retirement, their final financial destination. There are many ways to get there, but which road you travel ultimately depends on your preferences and personal finances. One fork in the road is choosing how to invest your savings.
Two common choices are the Individual Retirement Account (IRA) and the employer-sponsored 401(k). The decision isn’t always easy. For example, a Roth IRA offers exceptional tax benefits, making it an outstanding retirement planning tool. But between a traditional IRA and a 401(k) plan, I absolutely prefer the latter. Here’s why.
Meet your contenders: The 401(k) and the traditional IRA
Are you not already a retirement expert? Don’t worry. Here are the basics of 401(k) plans and traditional IRAs.
Retirement pensions have become increasingly rare in modern enterprises, putting more responsibility on individuals to plan for retirement. Many employers have dropped pensions in favor of the 401(k) plan. Workers can invest money from their paycheck for retirement using a 401(k). It also comes with immediate tax benefits. For example, taxes on 401(k) contributions are deferred until retirement, meaning you can lower your taxable income during your working years by contributing more to your 401(k).
However, not all companies offer a 401(k) plan. Meanwhile, IRAs are more widely available because anyone can open one, even if you have a 401(k). That’s right, this isn’t a one-or-the-other choice. Traditional IRAs defer taxes on contributions, similar to 401(k) plans. You also get a bit more flexibility with IRAs. Most 401(k) plans limit investment choices to mutual funds and exchange-traded funds (ETFs), but you can own individual stocks and other assets in an IRA.
Remember that these are the basics, and different variations of 401(k) plans and IRAs exist. If you have any questions about the rules or tax implications of each, don’t hesitate to contact a financial advisor.
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Now, IRAs sound pretty nice, and admittedly, having that extra control might appeal to many investors. So, why do I still prefer the 401(k)?
1. 401(k) plans have higher contribution limits
Investing boils down to the numbers. Your nest egg in retirement will depend on:
- How much you invest.
- How early you start.
- The return on your investments.
As excellent a tool as IRAs are, they can have somewhat restrictive contribution limits. For 2024, the annual contribution limit for traditional IRAs is $7,000. Exceed that, and you’ll face stiff tax penalties while that money is in your IRA. You can contribute an additional $1,000 per year starting at age 50, but it undoubtedly puts a ceiling on your long-term investment potential, especially for higher earners or super savers.
Meanwhile, employees can contribute up to $23,000 to their 401(k) plan in 2024, and those 50 or older can add $7,500 as catch-up contributions. It’s far easier to build life-changing wealth in a 401(k) than an IRA, and it’s not close.
2. Many 401(k) plans offer a chance at free money
If that wasn’t enough, some 401(k) plans offer an employer match to incentivize employees to participate. This is generally a sum added to a 401(k) in addition to one’s contributions based on a specified percentage. For example, suppose your 401(k) plan matches dollar-for-dollar up to 3% of your salary.
That would mean that if you make $100,000 and contribute 3% of that ($3,000), your employer would kick in an additional $3,000. It’s as close to free money as you’ll find in the real world, and that can make a tremendous difference over decades of earning and saving. Plus, a match doesn’t affect your individual contribution limit! The government will allow up to $69,000 in total contributions in 2024, and $76,500 for those 50 or older.
3. 401(k) plans help you keep it simple for your own good
In my view, the option to hold stocks and other assets in an IRA doesn’t overcome the sheer difference in how much you can invest through a 401(k). But if IRA flexibility still appeals to you, consider this.
A 401(k) generally restricts investment choices, which could actually benefit most people. Unfortunately, most people lack the knowledge and time to invest most of their wealth in individual companies. Most people are better off investing their savings in diversified, maintenance-free funds. You can set it and forget it.
That way, you don’t have to worry about inexperience or bad decision-making torpedoing your nest egg as you approach your golden years.
Do you want to open a brokerage account and take some risks? Want to have some fun with speculative stocks? Fine. Just don’t do it with your life savings. That’s not to say that those with IRAs would necessarily act that way, but using a 401(k) means you won’t even have the opportunity to make such an expensive mistake in the first place.