Questions You Must Ask When You’re Choosing Between an IRA and a 401(k)

Have you been avoiding setting up a retirement account because the information is overwhelming and complicated? Yeah, me too.

I’m not going to lie; if it wasn’t for the automatic enrollment in my employer’s 401(k) when I was 26, I wouldn’t have started saving for retirement when I did.

As my savings — and age — grow, so does my concern about retirement.

Why did I wait so long to start saving? Will it be enough when I retire? Is there more I can do now? I guess this means I’m full-on adulting.

Instead of worrying about what I can’t control, I’ve shifted my focus to what I can control: how much money I save and where I save it.

And so can you.

With a little research, personal questioning, and maybe even a list of pros and cons, I’ve figured out the right retirement savings option that fits my lifestyle.

Let’s see if we can help you find yours.

What Is a 401(k)?

A 401(k) is an employer-sponsored retirement savings plan where contributions are generally deducted from your paycheck before taxes.

The money in your 401(k) grows over time due to investments made on your behalf in mutual funds, stocks and bonds. With a few exceptions, you cannot withdraw money from your 401(k) until you’re 59 ½ without a 10% penalty.

Your contributions are tax-deductible, but you must pay income taxes on the money you withdraw.

You’re not required to make withdrawals until you’re 70 ½. Then, you are required to take minimum distributions.

As of 2019, you can contribute up to $19,000 per year to a 401(k). There are no income restrictions, and your contributions do not count as taxable income.

When Should You Invest in a 401(k)?

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A 401(k) might be a good retirement savings option for you if you answer “yes” to any of these questions:

Does your employer offer a 401(k) and match your contributions?

If so, this perk can maximize your retirement savings. It’s basically free money.

Is an automatic paycheck deduction in line with your saving style?

Payroll deductions are seamless and hassle-free. You never see the money, so you won’t be tempted to spend it.

Could you use the lower income tax?

All those automatic payroll deductions are pulled out before taxes, which reduces your annual taxable income. That could result in you falling into a lower tax bracket or receiving higher income tax returns.

Have you reached your IRA’s maximum annual contribution?

If you’ve hit the annual max contribution for a traditional or Roth IRA, you can still contribute to a 401(k). Its annual contribution limit of $19,000 allows for mega saving.

Are you in a high tax bracket and not ready to pay taxes on your investment?

If you are in a higher tax bracket, it might be better to pay lower taxes by putting pretax money into a 401(k). This is especially helpful if you think you may fall into a lower tax bracket when you’re ready to start making withdrawals.

What Is an IRA?

An IRA is an individual retirement account that is not attached to an employer. It stays with you regardless of where you live and work or your marital status.

You open an IRA on your own, and as of 2019, you can invest up to $6,000 per year — or $7,000 once you’re 50 or older — in addition to any 401(k) contributions.

You contribute when it’s convenient for you and choose what mutual funds, stocks and/or bonds you want to invest your money in.

Most IRAs do not have a minimum opening deposit, but there might be purchase requirements on some investments and a mandatory annual contribution.

Your contributions to an IRA may be fully tax-deductible depending on your financial situation, but your withdrawals are taxed as income. You can withdraw money from your IRA once you’re 59 ½ without the 10% early withdrawal penalty with a few exceptions. You’re also required to make a minimum annual withdrawal once you’re 70 ½.

What About a Roth IRA?

Traditional and Roth IRAs are similar, but there are a few key differences.

One of the biggest distinctions is your contributions to a Roth IRA are taxed, meaning you pay taxes now instead of later. It’s totes tax-free on the back end, though. Woo!

Roth IRAs do have income limits. As of 2019, individuals who make more than $137,000 per year or married couples who make more than $203,000 a year cannot contribute.

Like a traditional IRA, maximum annual contributions for a Roth IRA are capped at $6,000 — or $7,000 once you’re 50 or older.

You can withdraw the money you contribute before age 59 ½ without penalty since you already paid taxes on it, but there’s a 10% penalty on the earnings if you withdraw it before 59 ½. You can skip the early withdrawal penalty if it’s for college, medical bills or first-time home purchases.

Unlike a traditional IRA, a Roth IRA has no mandatory distribution requirement, which means you will not be forced to take withdrawals at 70 ½.

As with a traditional IRA, you must make your own investments with a Roth IRA.

When to Invest in an IRA or a Roth IRA

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Opening a traditional IRA or Roth IRA might be a good option if your situation fits some of the following criteria:

Your employer doesn’t offer a 401(k) match or other retirement plans.

IRAs are great DIY saving options because they’re not attached to an employer. An IRA allows you the freedom to invest on your terms regardless of your situation, especially if you don’t have access to a 401(k).

You’re a job hopper or don’t plan to stay at your current employer for long.

It’s becoming more common to change jobs frequently, and with it comes the pain of perpetually rolling over your old 401(k). An IRA stays in one location while you seize all the job opportunities.

You prefer to choose how and where your money is invested.

IRAs give you complete control over the type, quality and amount of investments. You can manage it yourself, whereas in a 401(k), you’re paying to have someone else manage it for you. It’s like making your own dinner at home or going out to eat. Essentially, an IRA is like picking the ingredients and setting the oven to “bake.”

You’re in a low tax bracket.

If you’re young and in a low tax bracket, consider a Roth IRA. Seriously, you pay the lowest possible taxes now and reap the rewards later.

If you plan to fall in a higher income bracket when you retire, or you don’t want to gamble on future tax rates.

Paying taxes on Roth IRA investments upfront is ideal if you’re studying for a high-income profession or climbing the corporate ladder. The more you earn, the more you’ll pay in taxes in the long run. There’s also risk with withdrawing later — who knows what the tax brackets might be in 30 to 50 years.

You’ve reached the maximum annual contribution limit on your 401(k).

If you’ve reached the $19,000 limit on your 401(k), you could still invest up to the maximum amount in an IRA.

You want to make a contribution for last year.

You can contribute to your IRA for the previous year up until the tax filing deadline of the current year.

IRA vs. 401(k): Final Considerations

No matter which option you choose, don’t forget to check the fees and do comparison shopping. It’s a competitive marketplace, and some plans include value-added services, resource tools and automatic withdrawals.

“There is no set it and forget it,” said Catherine Collinson, CEO and president of Transamerica Institute. “No one has more vested interest in the outcome of your retirement savings than you and your family.”

One way or the other, future you will be oh so happy to have a stash of cash. Even if you can only contribute $100 per month, the interest on that money will compound over time and help you when you might need it the most.

“The single most important thing is to save for retirement and to save on a consistent basis,” Collinson said.

In the words of Ice Cube, check yo’ self before you wreck yo’ self in retirement — OK, the last two words were mine.

Or there’s the other saying, “Get rich slowly, or get poor fast.” I’ll take the former, please.

Stephanie Bolling is a former staff writer at The Penny Hoarder. 

This article originally appeared on The Penny Hoarder