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Traditional IRA vs. 401(k)

May 24, 2024 | Advice, Daniel Lattimer, Financial Planning, North America, Pensions, Retirement, US Expats

Traditional IRA vs. 401(k)

May 24, 2024 | Advice, Daniel Lattimer, Financial Planning, North America, Pensions, Retirement, US Expats

Exploring the Advantages of Traditional IRAs

When planning for retirement, two common savings vehicles often come into consideration: the traditional Individual Retirement Account (IRA) and the 401(k) plan. Both offer distinct benefits, but understanding the differences can help investors make informed decisions about which is best suited to their needs. Below, we’ll explore the advantages of traditional IRAs over 401(k) plans.

1. Investment Flexibility

Traditional IRAs often provide a broader range of investment options than 401(k) plans. With a 401(k), employees typically select from a limited list of mutual funds or exchange-traded funds (ETFs) chosen by the plan administrator. In contrast, traditional IRAs offer the flexibility to invest in a wide range of assets, including individual stocks, bonds, ETFs, mutual funds, and even alternative investments like real estate or precious metals . This variety allows for more personalized and diversified portfolios tailored to individual risk tolerances and investment strategies.

2. Greater Control and Autonomy

Traditional IRAs offer more direct control to investors over their retirement savings. This contrasts with the employer-managed 401(k), where employees rely on their employer’s plan options and policies. With a traditional IRA, account holders have the autonomy to make decisions about investment selection, contribution timing, and rollovers without needing employer approval .

3. Potential for Lower Fees

The fees associated with 401(k) plans can vary widely and may include administrative costs, management fees, and fund expense ratios. Employers may pass on some of these costs to employees, reducing net returns. Traditional IRAs, especially those with low-cost brokerage accounts, can potentially have lower fees, particularly if the account holder carefully selects low-cost investments .

4. Access and Withdrawal Flexibility

Traditional IRAs generally offer more flexibility in terms of withdrawals compared to 401(k) plans. While both accounts penalize early withdrawals before age 59½, traditional IRAs allow for penalty-free early withdrawals under certain conditions, such as for a first-time home purchase, qualified higher education expenses, or significant unreimbursed medical expenses . In contrast, the criteria for 401(k) hardship withdrawals are typically stricter and determined by the plan provider.

5. No Dependency on Employer

A key advantage of traditional IRAs is their independence from any specific employer. Workers can open and contribute to a traditional IRA regardless of their employment status, which is beneficial for those between jobs or those who work for employers that do not offer a retirement plan. This flexibility allows individuals to maintain consistent retirement contributions even during career transitions .

6. Roth Conversion Potential

Traditional IRAs also provide the opportunity for account holders to convert their traditional IRA to a Roth IRA. This conversion allows individuals to pay taxes on their traditional IRA contributions now, enabling future withdrawals to be tax-free. This strategy can be advantageous for individuals expecting to be in a higher tax bracket in retirement, offering tax-efficient planning options that 401(k)s do not directly provide .

7. More Flexibility with Required Minimum Distributions (RMDs)

While both traditional IRAs and 401(k)s are subject to required minimum distributions (RMDs) beginning at age 73 (as of 2023), traditional IRAs offer more flexibility in handling these distributions. With a 401(k), account holders are generally required to take RMDs separately from each 401(k) they hold. However, traditional IRAs allow individuals to aggregate their RMDs, meaning the total required amount can be withdrawn from any one or a combination of traditional IRAs. This offers greater flexibility in managing taxes and optimizing withdrawals.

Moreover, for individuals still working beyond age 73, the IRS permits postponing RMDs from a 401(k) if the employee continues working for the employer that sponsors the plan. However, this provision does not apply to IRAs, making it crucial to understand the nuances of both retirement vehicles.

7. More Flexibility with Required Minimum Distributions (RMDs)

While both traditional IRAs and 401(k)s are subject to required minimum distributions (RMDs) beginning at age 73 (as of 2023), traditional IRAs offer more flexibility in handling these distributions. With a 401(k), account holders are generally required to take RMDs separately from each 401(k) they hold. However, traditional IRAs allow individuals to aggregate their RMDs, meaning the total required amount can be withdrawn from any one or a combination of traditional IRAs. This offers greater flexibility in managing taxes and optimizing withdrawals.

Moreover, for individuals still working beyond age 73, the IRS permits postponing RMDs from a 401(k) if the employee continues working for the employer that sponsors the plan. However, this provision does not apply to IRAs, making it crucial to understand the nuances of both retirement vehicles.

Conclusion

While 401(k) plans are essential retirement vehicles with their unique benefits, traditional IRAs offer distinct advantages in terms of investment flexibility, autonomy, fees, access, and employer independence. Understanding these differences is crucial for individuals seeking the best strategy for their retirement planning goals. Ultimately, whether an individual chooses a traditional IRA, a 401(k), or a combination of both will depend on their specific financial situation and retirement objectives.

Written by: Daniel Lattimer – Independent Financial Adviser

This communication is for informational purposes only based on our understanding of current legislation and practices which are subject to change and are not intended to constitute, and should not be construed as, investment advice, investment recommendations or investment research. You should seek advice from a professional adviser before embarking on any financial planning activity. Whilst every effort has been made to ensure the information contained in this communication is correct, we are not responsible for any errors or omissions.

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Personal advice, whenever it suits you.