Comparison of 401(k) and IRA
When I teach Personal Finance at DMACC, I love to ask the students "other than contribution limits, what is are differences between an IRA and a 401(k)?"
The similarities are plentiful. Both come in before tax and after tax (Roth) versions and both offer tax deferred growth. The easy difference is the contribution limits. In 2012, you can contribute $17,000 to a 401(k) ($22,500 if you are age 50 or older) versus a maximum contribution of $5000 ($6000 if you are age 50 or older) to an IRA. But there are two primary differences many retirement investors overlook; one is an advantage and the other is a disadvantage.
The advantage of a 401(k) is free money from the employer. 401(k)'s are a form of defined contribution profit sharing plan. Employers offer incentives for employees to participate because the highly compensated employees (that is generally the owners and executives of the company) may be limited in their own involvement unless enough "rank and file" employees participate. It is not unusual to see a matching incentive where the company adds to an employee's contribution. For example suppose the employer offers a match of 50% of the first 6% contributed. If the employee makes $100,000 per year and contributes $6000 to the 401(k), the employer will add an additional $3000 to their contribution. Who wouldn't be happy with a 50% "return" on their investment in the first year? The employer's money may be subject to vesting requirements, but in most situations employees are fully vested after 6 years of eligibility. Once an employee has received the employer's money and has become fully vested, there is no additional advantage to the 401(k) over an IRA.
The advantage of an IRA is an issue of control. Most retirement plan participants do not realize that they do not own their accounts. Retirement plan assets are owned by a trust, for the benefit of the employee. The trustee, who is often also the employer, has a fiduciary responsibility to act on behalf of the employee in the employee's best interest. Precedence has been established that this responsibility includes offering a reasonable selection of investments but limits the participants to only those investments offered inside the 401(k) plan. On the other hand, IRA's are owned and controlled by an individual who is free to invest in any investment which can legally be held in an IRA. Furthermore, since only the account owner can authorize a distribution, it is sometimes a lengthy process to get money out a 401(k).
So once the free money is fully vested, there is no good reason to maintain a 401(k) over an IRA. I generally recommend a tax free direct transfer from a 401(k) to an IRA whenever someone changes employment or is eligible for an in-service distribution. By doing that, they are better able to control their investment and the timing of their withdrawals.
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