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Money Monday – How a 401(k) Usually Beats an IRA

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Although most people use these two terms interchangeably, legally there are huge and important differences between the two. First off, while anyone with earned income (or has a spouse who earns income) can put money into their IRA, 401(k)s can only be used by employees of a company who chooses to offer a plan. Although there are very few hard-and-fast rules in personal finance (definitely one of the most frustrating things as a consumer!), in most cases the use of a 401(k) is better than an IRA. Both psychologically and legally there can be great benefits. 

When a 401(k) is used, the money is taken directly from an employee’s paycheck, which means they never see the funds and rarely have a chance to miss that money. As humans, most of us are really good at using all — or even more — of our money up, even when we have the best of intentions. Utilizing a 401(k) makes sure that money you promised yourself you were going to save actually gets saved. Whereas with an IRA it is very easy to say you’ll make the contribution but then never get around to actually doing it. 

Another way the 401(k) beats the IRA is in how much a person can contribute. Because both of these are great ways to delay paying taxes, the IRS imposes limits on how much money can be put in every year to make sure that wealthier people don’t abuse these tools. A 401(k) can accept $19,500 of new employee money every year, while the IRA limit is set at $6,000. In many cases a 401(k) employer will even promise to match a certain percentage of their employees’ savings. This match is above what the employee can contribute. Employees should think of their employer match as part of their compensation; if they aren’t getting that match they are leaving money on the table!

I would say the biggest legal benefit to a 401(k) is that the company who runs it has a fiduciary duty to find the best plan for their employees. That means they are legally obligated to do what’s best for their employees when it comes to running and overseeing the retirement plan. 401(k) plans (and many other company-offered retirement plans) are overseen by its own law, the Employee Retirement Income Security Act of 1974 — more commonly known as ERISA — which sets minimum standards for things such as how employers communicate the plan to their employees, what kind of investment options employees have, who has the ability to control funds, and allows employees to sue if an employer breaks their fiduciary duty. IRAs don’t have these same protections and it is an unfortunate fact of the personal finance industry that there are some bad actors who take advantage of our country’s financial illiteracy. 

Another difference to note between the 401(k) and the IRA is that companies can choose to allow employees to borrow from their 401(k), whereas loans are strictly prohibited with IRAs. This can be a game-changer for families who come upon an emergency and need funds quickly. I’ve even seen some people use a 401(k) as a short-term bridge when buying a new house before their current one sells. The interest rates are often equal to or better than a personal loan from a bank would be and it’s easier to “qualify” because the money is already yours. This isn’t possible with an IRA. 

A benefit to an IRA can be that you are allowed to invest in far more types of securities. This can be both a blessing — for those who don’t like the constrained options their 401(k)  plan allows — and a curse — many people freeze when presented with too many options and end up doing nothing. 401(k) providers create a limited menu of investments that meet certain criteria for diversification, risk, and potential return. These options must be reasonably priced and allow employees to blend a portfolio to suit each individual. The IRA busts that constraint open and allows an account holder to invest in almost anything that can be invested in, with only a few exceptions. In the hands of someone who knows what they are doing, this can be an opportunity, but for the vast majority of Americans it is a risk.

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