401(k) vs. IRA: Navigating the Employee Options

Take it to the bank—these days, offering employees retirement benefits is an expectation, not an exception. Namely’s survey data shows that 90 percent of job applicants said they’d think twice about joining a company without 401(k) offerings. But when it comes to the nitty gritty, how many employees actually understand how retirement plans work?

More often than not, HR teams are called upon to field employee retirement questions. Of those inquiries, a sizable number relate to the differences between 401(k) plans and individual retirement accounts (IRAs).

To help you get ahead of those questions, we’ve summarized the key differences. Note that the below applies only to traditional, or tax-deferred retirement plans.

401(k) Plans

The term “401(k)” has become synonymous with retirement itself, and for good reason—according to research conducted by the U.S. Census Bureau, nearly 80 percent of Americans work for a company that offers a 401(k). But in reality, they only represent a piece of the puzzle.

Simply, a 401(k) is an employer-sponsored retirement plan that allows individuals to set aside a percentage of their paycheck on a pre-tax basis. The IRS can only tax an employee for this money after he or she retires and begins withdrawing funds. These withdrawals are subject to federal and state income taxes, the rates of which are based on what the retiree’s tax bracket is at the time.

If employees face a hardship and need access to these funds before retirement, they’ll face a tax penalty. Individuals younger than 59 ½ years old are assessed an additional 10 percent penalty on top of the taxes mentioned earlier.

Individual Retirement Accounts (IRAs)

Contributing to an IRA is another great way to save for retirement. Employees can open these tax-advantaged accounts on their own through their bank or a broker. They are the sole owners of these accounts, hence the “individual” in IRA.

Similar to traditional 401(k) plans, the funds you set aside in an IRA are not taxable until you withdraw them. At retirement, these withdrawals are subject to regular income taxes. But as an added benefit, contributions made to these accounts can be deducted from individuals’ annual tax returns, so long as they aren’t Roth, or post-tax contributions.

As mentioned earlier, those who withdraw funds before age 59½ are subject to a 10 percent tax penalty. And if you’re considering whether to put off retirement for a few years, keep in mind that individuals are required to start withdrawing funds from their IRAs once they turn 70 ½ years old.

Key Differences

As you might have gleaned already, the big difference between a traditional 401(k) and IRA is that the former is employer-sponsored. IRAs are driven entirely by the individual. But unlike IRAs, 401(k) plans may also be eligible for an employer match, or a commitment to contribute a certain amount to an employee’s retirement account based on what he or she pays.

As of this writing, nearly half of businesses with 401(k) plans contribute 50 cents for every dollar contributed, up to 6 percent of the respective employee’s salary. According to some industry experts, a “dollar for dollar” approach is quickly becoming just as popular.

The plans also differ in respect to how much can be contributed to them per year. As of 2018, employees can annually defer up to $18,500 to their 401(k), or $24,500 if they’re age 50 or older. In stark contrast, IRA holders can only contribute up to $5,500 annually. An additional $1,000 is permitted for those who are age 50 or older. These higher, age-based exceptions are commonly called “catch-up” contributions.

Employers and HR teams alike are uniquely positioned to empower workers to save for retirement. That said, among all age groups it might be millennials who have the most catching up to do.
 A 2018 study by the National Institute on Retirement Security found that over two thirds of young workers don’t have anything saved for retirement.

Thankfully, it’s not too late to change course and get millennials on the path to financial security. Read our ebook, How to Empower Millennials to Save for Retirement, and learn what strategies companies are using to boost retirement plan participation.

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