Comparing The 401k Vs Traditional IRA

When considering retirement options, it can take a lot of time to understand what options are available and how one option compares to another. As everyone is growing older and retirement is looming for millions, there are still generations of working people that have no idea where or how to start investing for their retirement years. Basic retirement investing is low on their list of priorities because the age of retirement seems so far off in the distance. What they don’t understand is that thanks to the magic of compound interest, a dollar saved when you’re young is many times more valuable than a dollar saved later in life.

The Traditional IRA

Individual Retirement Accounts, or IRAs, are a personal savings account that allowing you to save money for retirement with pre-tax dollars. There are several kinds of IRAs available, but we’ll focus on just the traditional IRA for the purposes of this discussion.

Here are the basics…

• The 2010 contribution limit is $5,000 (plus an additional $1,000 for those age 50+)
• You can invest your IRA in practically anything you want
• Contributions are tax-deductible in the year you make it
• Withdrawals are taxed as regular income
• You can start to withdrawing from the account penalty-free at age 59 ½; otherwise, you will be subjected to a 10% early withdrawal penalty (excluding certain exceptions, such as SEPPs).

The 401k Plan

You probably already have the option of investing in a 401k retirement account at work, often with the benefit of an employer match.

While 401k’s have similar tax benefits as Traditional IRAs, there are important differences…

• For 2009 and 2010, the maximum contribution is $16,500 (plus an extra $5,500 catch-up contribution for workers age 50+).
• Employers can limit the amount you are allowed to contribute to a percentage of your pay (although this is rare).
• Like with a Traditional IRA, contributions are tax-deductible and withdrawals taxed as regular income.
• There is a 10% early withdrawal penalty for workers less than 59 ½ years old, exception certain 401k hardship withdrawal exceptions.
• Unlike with IRAs, your investment options are generally limited by your plan administrator.  Most plans have a very limited array of sub-par investment options.
• You may be eligible to borrow against your 401k (bad idea).

Which Is Best For You?

For most people, the 401k is going to be the better option for two primary reasons.

1. Higher contribution limit – When it comes down to it, the amount you save is going to be far more important than your return on investment, within reason.  Saving $15,000 per year in a crappy fund earning 7% is probably going to beat saving $5,000 per year in a good fund earning 8%.
2. The employer match – There’s no such thing as a matching IRA contribution, which is too bad.  A match is free money.  You’d have to be insane to turn it down.

That said, if you don’t have access to a 401k at work, a Traditional IRA is a great investment vehicle.  You can gain access to the best funds money can buy from the best mutual fund companies around, which is more than you can say for most 401k plans.