401(k) or IRA?

Decoding retirement savings is as thrilling as an all-day cram session for a standardized test. I get that. But just like that grad school exam, your future depends on it.

A few weeks ago, I sent my focus group a quick survey on 401k plans. I knew 401ks are confusing?even to someone who?s been writing about them for years?but I was interested in what, specifically, you want to understand better about 401ks.

Over the next few weeks I?ll publish several posts that answer your top questions about at-work retirement plans. Starting with: Should I contribute to a 401k or an IRA?

Note: We?ll be talking about 401ks?the most popular at-work retirement plan. Non-profits and other institutions may offer 403b plans. Although there are some differences, if you have a 403b plan, most of what we cover will apply.

Today we?ll look at the pros and cons of a 401k or other retirement account at work versus an IRA that is a self-directed retirement account.

Save Something. Anything!

At work or on your own, everybody should save something for retirement. According to a recent survey, 55% of Gen Y have not started saving for retirement. No surprise. But we need to start.

Look at the reasons people give for not contributing to their 401k:

(Are you eligible for a 401k or 403b but don?t contribute? Let us know why in a comment. If it?s because of something you don?t understand, maybe we can help.)

Of course, lots of young people simply don?t have the scratch. It?s hard to set aside $50 a month when Two-Buck Chuck is your go-to drink and your iPhone is still on your parent?s family plan.

Others are confused or intimidated by investing. Still more get paralyzed by questions like: ?Should I use a 401k or IRA?? or ?What mutual funds should I invest in??

What?s important is to:

Are there exceptions? Only one: When you?re in credit card debt and paying interest over 10%. Even then, I wouldn?t fault someone for contributing a small amount to a 401k.

Now that we have that out of the way, let?s look at the differences between 401ks and IRAs.

401ks vs. IRAs At-a-Glance

401k	IRA
Employer-sponsored account	Individual account
Annual contribution limit: $17,000*	Annual contribution limit: $5,000*
No income limits	Income limits may apply
Investment options may be limited by plan	No limit on investment options
Can rarely be cashed out penalty-free except in retirement	Can sometimes be cashed out penalty-free

*For 2012; savers over age 59 ? are eligible to make additional catch-up contributions.

What a 401k Is (And Isn?t)

Before we dive in, there?s some confusion surrounding what a 401k plan actually is. One respondent asked:

?Wouldn?t it be better to do your own fund, such as a Roth IRA? I ask because with the current economy, many people I know lost up to half of their 401k.?

A lot of people think like this, in part due to the media commonly using people?s depleted 401ks as a sign of how the recession hurt everybody.

During the down economy, not everybody lost a job, but anybody with a 401k lost money. Only not everybody lost 50%. Investors with who were properly diversified fared better.

Both 401ks and IRAs are types of investment account. The IRS gives investors in both 401ks and IRAs certain tax advantages over a regular investment account, and also sets rules for how they can be used.

It?s helpful to think of both a 401k and IRA as buckets with which you fill will rocks (investments like stocks and mutual funds). Because everybody fills their buckets with different types and quantities of rocks, no two are the same. But this is where the similarities between 401ks and IRAs end. Let?s take a look at what makes a 401k different from an IRA, for better or worse.

401ks Have Limited Investment Options

With an IRA, you can invest in virtually anything. You can have an IRA that simply holds a savings account or an IRA with 100 different stocks, bonds, ETFs, and mutual funds. You can even have an IRA that makes loans to other people through a peer-to-peer lending network.

With a 401k, this usually isn?t the case. Your employer partners with a financial services company to administer your plan. That company then gives you a limited number of investment options (usually, but not always, these are mutual funds). If you work at a large company you may have a lot of investment choices. If you work for a very small company, however, you may only have 10.

For most people, having fewer investment choices is actually a good thing. Most people aren?t stock pickers and shouldn?t try to be architects of the perfect portfolio with hundreds of mutual funds. The problem, arises, however, when 401k plans only offer mutual funds that have unnecessarily high expense ratios.

If you work for a larger employer, you can research how your 401k stacks up in terms of investment choices and fees at Brightscope.

401ks Have Higher Contribution Limits

The whole point of 401ks and IRAs is that Uncle Sam is giving you a break on your taxes to encourage you to save for your retirement. Unfortunately, there?s a limit to this particular Uncle?s generosity: contribution limits.

And this is a big?differentiator.

In 2012, savers under 59^1/2 can contribute up to $17,000 to a 401k and up to $5,000 to an IRA. (For IRAs, this is an oversimplification, but bear with me.)

When you?re starting out, contribution limits are hilarious. There?s no way you?re going to come close to them. But as you earn more money, pay off debt, and get serious about saving for retirement, it?s another story. Especially if you?re saving in an IRA alone, $5,000 may not be enough to fund the kind of retirement you?re dreaming about. Advantage 401k.

401ks Let You Contribute Pre-Tax Dollars

Normally, if you earn $500 and want to invest it in McDonald?s stock, you first have to pay income taxes on it. So you pay $100 of taxes and invest $400 in a stock. Assuming you hold this stock for many years, when you sell it, you?ll need to pay taxes on the amount the stock has appreciated?called capital gains tax, currently 15%. So if the stock goes from $400 to $600, you?ll pay $30 in tax. The $500 you earned (before taxes) has become $570 for a 14% post-tax return.

Now let?s say you invest the same $500 amount in a 401k. Now, with a traditional 401k, you don?t have to pay income taxes on money you put in. So you earn $500 and can invest $500. When it appreciates the same amount, you?ll have $750. But now, you have to pay income tax on the entire amount?not just the gains?$150. You?re left with $600?a 20% post-tax return. Okay, so the extra $30 in this example isn?t impressive. But these are small numbers over a brief period of time. If that $500 were $500,000, that?s an extra $30,000 you get to keep.

Here?s another example:

*In our next post we?ll take a closer look at how Roth accounts?both IRAs and 401ks?compare to their traditional counterparts.

401ks and IRAs Have Early Withdrawal Penalties

Here?s the thing about retirement accounts: They?re meant for retirement.

The tax breaks Uncle Sam provides us on money saved in a 401k or IRA are incentives to save for retirement. So he also provides an incentive not to touch that money. This is the early withdrawal penalty.

If you withdraw cash from a traditional 401k or IRA before you turn 59^1/2 birthday, you will owe a 10% penalty to the IRS on top of ordinary income taxes.

IRAs provide a bit more flexibility in this arena, and there are a number of exceptions to the IRA early withdrawal penalty. You can, for example, use funds to cover higher education expenses and up to $10,000 towards the purchase of your first home.

With a 401k, you must prove severe financial hardship to obtain an exemption from the early withdrawal penalty. Some employers, however, allow you to take out a 401k loan. Essentially, you borrow money from yourself. Although this sounds like a great idea, it?s a slippery slope. Any money you borrow ceases to earn returns for you and, if you lose your job, you must repay the entire loan or pay income taxes and the 10% penalty on the outstanding balance.

The Bottom Line

The decision to invest in a 401k, IRA, or both is different for everybody and depends on another set of circumstances: Whether you are eligible for either a Roth 401k or Roth IRA. We?ll talk about that next time.

In the meantime, I will say this: for those eligible, 401ks are the easiest way to save for retirement. The limited investment choices can be a good thing because it simplifies your investment decisions, and the money is automatically taken out of your paycheck. So if your employer offers a 401k plan and you?re eligible, you should contribute to it. If you don?t have access to a 401k?or maxed one out?-and still want to save for retirement, you should open an IRA.

In a few days, we?ll take a look at another common and confounding question: When given the choice among a Roth 401k, Traditional 401k, a Roth IRA and a traditional IRA, which one(s) should you choose? We?ll also cover how much you should be contributing and how to select investments to obtain the right asset allocation.

What about you? Do you participate in your company?s 401k or 403b? If not, why? Let us know in a comment.

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