Should You Invest In a 401(k) or an IRA? (And What’s the Difference Between Them?)

“The question isn’t at what age I want to retire, it’s at what income.”—George Foreman, professional boxer and entrepreneur.

401k.

IRA.

There’s a good chance you’ve probably heard of the two terms above. Whether it was through family members explaining about investing early, the terms listed as a key benefit for an employment package, a recommendation by your bank, or doing some simple investment research online, these two acronyms keep popping up time and time again.

While they sound like parts of an algebra equation, understanding them is equivalent to understanding opportunities for employer-sponsored-retirement…and even personal retirement.

But why acronyms?

And why numbers?

What’s the difference between a 401k and an IRA?

A running meta-joke in the investment-firm-sphere is that everything related to investing is made obtuse on purpose; so the average person is locked out of the discussion and forced to hire an advisor. Doing some digging reveals that the truth has more to do with tax-labels than it does an army of shadow-puppet-investors trying to screw the common man.

A Brief History Lesson (For The United States At Least).

In the 1970’s, a group of investors and business-types approached Congress for the possibility of contributing a portion of their salary to the stock-market…but the portion wouldn’t pay taxes until it was withdrawn. When this measure was accepted and passed as part of the Revenue Act of 1978, this addendum to the IRS taxation laws was labeled under a section which happened to be under part 401(k).

The IRA (Individual Retirement Account) was created as part of the Employee Retirement Income Security Act of 1974; it was deemed acceptable to create a fund where a person could save for retirement and gain interest on those funds outside of a company-sponsored plan.

Even with these acts in mind, not every employer or company offers a 401(k). Employers operating in different countries may offer different investment packages or opportunities.

This is why some prefer having an account they control themselves…if one continues to hop between jobs, then an IRA may be more ideal than continuously having to roll over a 401(k) between employers.

The Main Differences.

1. Who Is In Control of What: Most 401(k)’s are sponsored by large companies or private businesses. They act as a benefit for both the employee and employer to allot wages to enter the stock market without having to be taxed beforehand. An IRA is an account usually sponsored by a bank or investment firm; it is not required that the holder be an employee of said bank or firm.
2. How Much You’re Able to Deposit: The maximum amount that can be deposited—for those under 50—into an IRA is $6000 in 2019. $19,000 is the maximum limit for a 401(k). Furthermore, a 401(k) can usually be started without any sort of deposit. IRA’s typically involve deposits around $1000.

What This Means For You.

Fast-forward to 2019 and this has huge implications for us today—especially if you are young or starting your first ‘real job’ out of college! Every financial-advisor and wannabe-personal-finance-guru will bombard you with the clichés of ‘save early, save often’ or something of that nature. However, putting the investment into practice is a bit more nuanced.

It is good to stress the importance of early saving and investing habits early if possible. Even if you are only looking at socking away $50-$100 during your late teens or early college years, getting into the habit of monthly investing is a habit that leads to better financial security as your 20’s roll by.

We’ll Start With The 401(k).

Let’s assume that you start a new job and choose to enroll in the job’s 401(k). After you’re registered, a portion of each paycheck is deducted and put into the bracket of funds collected by the 401(k)…

(Normally an article like this would stop and explain the types of funds bundled in a 401(k), who owns the funds, and how the stock market works. This could take up a whole series of articles. For now, just run with the idea that your money is earning money from the compound interest present in these organized mutual funds).

Mutual funds (n.): A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities such as stocks, bonds, money market instruments, and other assets. (Definition of mutual funds from Investopedia.org).

Compound interest (n.): interest calculated on the initial principle, which also includes all of the accumulated interest from the previous periods of a deposit or loan. (Definition of compound-interest from Investopedia.org)

These shares will start to collect interest over time. For the sake of an easy model, let’s assume that 6% of a $50,000 salary gets allotted from each paycheck into the 401(k). This accounts to roughly $250 a month being set aside Assuming a bi-weekly pay, let’s watch $250 accumulate over a time span of 45 years.

Let’s also assume a standard employer match of 3%.

The employer match is a service provided by the employer to contribute an additional amount based on your own contribution. This contribution varies depending on the company you work for. Some employers offer a match right away, some employers offer it after a fixed period of service, and others don’t offer a match at all. An employer match is equivalent to the company rewarding you for putting money aside (and sticking with them in the long run).

Finally, let’s assume (for the sake of an easy model to understand) that you never make more than $50,000 a year for the rest of your life.

Let’s take a look:

Somewhere in the ballpark of $900,000

Not a million dollars…but not too shabby of an amount to retire on.

Again, this is a crude model and it assumes a number of things:

-No contribution greater than $200 is made during this period of 40 years.

-Your employer did not offer a 401(k) match.

-Your salary, lifestyle, or necessities did not change over forty years.

-You worked at the same company for forty years.

-You had no life-event that demanded you take out some money early.

Like I said, the model is crude, but you see my point regardless. If you start investing in a 401(k) at age 25, you can take advantage of early compound interest to have a good nest egg built up by the time you hit the 60’s. That’s the overriding point we should take home.

The Same Goes For An IRA.

Since the maximum contribution for an IRA is $6000, let’s go ahead and run that as a model that uses a monthly deposit—$500 as a rule. Not only will we start with $1000, we will use the assumed standard of an average 7% return on our monthly investments over a period of 45 years; we will be looking at an ideal scenario involving age 25 to 70.

That’s 1.5 million before taxes and 1.3 million after! Holy smokes!

Again, this is just an example of the power in compound interest, as well as the benefits of saving early. If you were to start at age 30 instead of 22, you would end up netting somewhere around $860,000, losing out on nearly $700,000. Regardless if you choose to use an employer-sponsored-retirement-plan or one made by an investment firm, you stand to collect heavy dividends if you keep plugging money month after month.

For some, these plans can bring a sense of financial security.

Others may not be so lucky…

Conclusion.

Make no mistake, taking advantages of either a 401(k) or an IRA is a great opportunity when you’re young and getting into the workforce. However, these types of investment programs operate under the assumption that you have paycheck money to spare. It also assumes that the money you do have to spare is enough to either meet the minimum requirements for a deposit—like the standard $1000 for an IRA. For those coming from backgrounds where money is in short supply, it’s an ordeal to even try to start investing.

This is where we have to get creative. This is where I had to get creative. If you’re in a life-period where your main job—or two—is barely covering your living expenses, then you may have to start thinking outside the box when it comes to early investing.

This may involve everything from doing side hustles or freelance work in-between the cracks of what little free time you have. It may involve finding creative ways to save your first $1000.

In any case, the power of long-term-retirement-plans—and the compound interest they provide—is something every young person should look into whether they enter the workforce straight out of high-school, or begin to look for a job after college.

If you manage to start saving early, future you will soon thank you…

…no time-travel required.

A second part to this article details the differences between a Roth 401(k) and a Traditional 401(k). The second part can be found here.

*(It should be noted that these models do not take federal, state taxes, marital status, or income tax into these equations. All models are illustrated solely for the purpose of showing what is possible though compound interest. People who are looking for solid financial models and advice should consult with a licensed professional before deciding. All other disclosures can be read in our Privacy Policy).