Your 401(k): A Crash Course

There are many different retirement savings vehicles out there, which can be both a blessing and a curse. On the plus side, it means that your options are plentiful; in talking it over with your financial advisor, you can identify a retirement savings plan that’s right for your goals and your financial status. The downside is that, for many investors, it is simply overwhelming to sort through the options and pinpoint what each has to offer.

Case in point: Everyone is familiar with the term 401(k). What you may not know is exactly what this investment vehicle offers in relation to other retirement accounts. Should you have a 401(k), or an IRA? Or could you benefit from both? Before you can answer, you have to know what a 401(k) involves.

401(k)s and IRAs

Like the IRA, the 401(k) is a retirement investment and savings vehicle. The biggest difference is simply this: An IRA is something you set up on your own, outside the context of your employer, while a 401(k) is employer-sponsored. Anyone can set up an IRA, but only some companies offer 401(k)s—and if yours does not, you cannot simply establish one on your own.

There are other distinctions, too. With an IRA, you can decide how much you want to contribute each year—limited by your age and other factors. With the 401(k), the plan is set up so that part of your salary is automatically invested. As an added benefit, many employers will match whatever you choose to contribute from each paycheck.

A 401(k) is tax-deferred. That is, you do not pay any taxes on it until you make a withdrawal. With an IRA, you have the option of either a Traditional or a Roth, which offer different tax advantages.

The 401(k) Dilemma

There are some obvious advantages to this retirement savings vehicle, not least the employer match. The issue with the 401(k) is that it is tied to your employment—which begs the question: What happens when you decide to change careers?

One option is to simply empty the account, which is a possibility but not always a good one. You will incur a 10 percent penalty, in addition to having to pay all applicable taxes. Another choice is to roll the money over into your new 401(k)—if you have one—though this is usually going to incur some high fees and bring with it limited investment opportunities.

Another course of action is going to be rolling your 401(k) into an IRA—which will result in lower fees, more options, and, most significantly, the chance to really formulate an investment strategy with a financial advisor.

There is nothing to prevent you from having a 401(k) and an IRA, though it is important to ensure you are being strategic and using them prudently, in tandem. For guidance in doing so, make sure you speak with your retirement advisor!