Disclaimer: This article is for general illustrative purposes and/or informational purposes only. It is not meant to serve as investment advice.
401(k) and Traditional Individual Retirement Accounts (IRA) are retirement savings accounts that let you set aside a fraction of your income today so you can enjoy a comfortable retirement in the future.
What Is a 401(k)?
A 401(k) is a tax-advantaged and employer-sponsored retirement account that enables employees to contribute either a percentage of or fixed amount from their earned income up to a certain income limit.
Typically, traditional 401(k) contributions are made on your pre-tax income. Hence, they are tax-deductible as they reduce your taxable income. The amount in this account can also grow tax-free until you make a withdrawal in your retirement, at which point income tax will be levied.
Employers may contribute to their employees’ 401(k) accounts by matching their employee contributions. This practice varies depending on the employer and is not consistent. Sometimes, an employer contribution may make a matching contribution dollar for dollar up to a certain percentage of your income or match a percentage of your contribution.
For Roth 401(k) accounts, the tax works in the opposite manner — your contributions are not tax-deductible, as they are funded with post-tax income. However, you do not have to pay any tax when you withdraw your money in retirement — essentially, free withdrawals — and your investments grow tax-free.
What Are the Pros and Cons of a 401(k)?
The primary benefit of a 401(k) is the tax benefit it offers. The contributions you make today reduce your taxable income for the year. This allows you to pay lesser tax now and may even reduce your marginal income tax rate on your annual tax return.
Additionally, your capital gains are not taxed until you eventually withdraw your funds, which is referred to as 401(k) distributions.If you think you will be in a lower income bracket after you retire, a 401(k) is a great option for you.
Depending on your employer, a fraction or the entirety of your 401(k) contributions may be matched, which can double your contributions. This is much higher than the average rates of return that most financial assets offer.
Lastly, workplace retirement plans are protected by federal law with the Employee Retirement Income Security Act (ERISA). This provides the account holder with a claim to certain benefits if they lose their job or if their workplace retirement plan is terminated. More importantly, ERISA ensures that your 401(k) account has guaranteed protection from creditors.
A fundamental disadvantage of the 401(k) or any retirement account is that it has strict limits on early withdrawal, making the investment quite illiquid. You will have to pay income tax and penalties on early withdrawals unless you qualify for certain reasons.
For most people, your money is locked up until retirement with no way to withdraw it penalty-free. Large contributions to your 401(k) account may mean you have less money for an emergency fund or a reduced standard of living until retirement.
While most employer plans offer a 401(k) option, there is considerable variation in the kind of plans. Your employer may not match your contributions or might only match a tiny fraction. The employer also dictates the asset classes you can invest in, giving you little autonomy over investment decisions.
Finally, a major disadvantage of a 401(k) is forced withdrawals. After you reach a certain age, you will be forced to withdraw some of the money from your account in what is known as minimum distributions.
Eventually, you will have to withdraw all your money from your account. Additionally, you will not be able to make any further contributions, preventing your investment from growing indefinitely.
What Is a Traditional IRA?
There are many different types of IRAs, including the well-known Roth IRA and the lesser known SEP-IRA. These accounts include various types of assets such as actively managed mutual funds and index funds.
A Traditional IRA is an individual, non-employer-sponsored retirement savings account. Your contributions to a Traditional IRA account are tax-deductible to a certain extent because you make it on your pre-tax income.
According to the IRS, your traditional IRA contributions may be tax-deductible — though that deduction may be limited if your income exceeds certain levels. Depending on your situation, in other words, your IRA contributions may reduce your taxable income.
A Traditional IRA can also be a self-directed IRA (SDIRA), which enables you to invest in various alternative asset classes and make investment decisions of your choice. In 2022, the maximum IRA contribution limit to your traditional IRA account is $6,000 per year — or a $7,000 annual contribution limit if you are 50 or older.
What Are the Pros and Cons of a Traditional IRA?
Like a 401(k) account, Traditional IRAs also offer key tax advantages. Your contributions are pre-tax, hence, tax-deductible, which means you can decrease your taxable income. Moreover, your investments are also tax-deferred in your Traditional IRA account, which means that you only have to pay tax when you withdraw funds in retirement.
The Traditional IRA plan gives you more autonomy and ownership over your savings. While 401(k) accounts are employer-sponsored and subject to changing rules and certain limitations, the Traditional IRA account is entirely under your control.
If you leave your job, you will not be able to contribute further to your employer’s 401(k) plan. You may be able to move those funds into a new employer’s 401(k) plan in what’s known as a rollover — but you may incur rollover fees. (If you become self-employed or join a small business, a rollover will likely not be an option.)
On the other hand,with your own traditional IRA account, you can continue with the same account even after changing jobs.
One of the biggest advantages of a Traditional IRA is that you can opt for a self-directed IRA (SDIRA). This allows you to invest in various alternative asset classes such as crypto, real estate, and private equity.
Investing across multiple asset classes enables you to diversify your portfolio, which can be more difficult in a rigid, employer-sponsored 401(k) account with limited investment choices.
The tax advantage of the traditional IRA comes with a huge caveat. You can only deduct your contributions from your taxable income if you meet certain predetermined guidelines. This is determined by your annual gross income and employer-sponsored retirement plans.
If your income is above a certain threshold, you might not be able to deduct any contributions while filing your taxes.
Similar to any retirement savings plan, your IRA funds are relatively illiquid. If you withdraw your money early, without a qualifying reason, you will be subject to taxes and early withdrawal penalties.
With IRAs, you’re essentially foregoing money in the present to use it in your retirement. This can adversely impact your savings for an emergency fund and your current standard of living.
Lastly, with great power comes great responsibility. Although your traditional IRA offers greater autonomy and flexibility in terms of investment options, you have the burden of ownership of your account. This means you have to be proactive and up to date with all your investments. Furthermore, you have to be cognizant of your risk appetite before making any investment decisions with your retirement savings.
What Are the Differences Between a 401(k) and a Traditional IRA?
Employers usually restrict the available investment options for their 401(k) plan to ensure that the account is not subject to high-risk investments. This means that you adhere to your employer’s guidelines and have little agency in determining your investment decision.
Conversely, a traditional IRA offers far more flexibility in terms of investment options, especially if you opt for an SDIRA (self-directed IRA).
In some cases, an employer may give you the option of a self-directed 401(k) account, which can give you direct control over which assets you want to invest in. Even if your employer does not have a self-directed 401(k) option, it is worth asking if they allow specific alternative investments like cryptocurrencies.
Whether through a self-directed 401(k) or a SDIRA,you can invest in over 100 cryptocurrencies by using Dorado. We enable you to select from a wide range of cryptocurrencies to optimize your personal portfolio and gains.
Ease of Use
A Traditional IRA is extremely easy to set up on your own and can be used continuously, regardless of your employer.
Dorado makes IRA account usage even more convenient by managing the administrative duties while you focus on the investment decisions.
Dorado also provides crypto exchange onboarding assistance and annual IRA compliance, plus a reporting service, which makes investing in a wide variety of cryptocurrencies easier than ever before.
How Are Taxes Handled With a 401(k) or a Traditional IRA?
In both cases, there is no tax charged on your investments, i.e. they can grow tax-deferred. You only need to pay taxes when you finally withdraw your money in retirement.
Similar to 401(k) accounts, Traditional IRAs are also tax-deductible. However, the amount of contributions you can deduct from your taxable income is subject to your annual gross income level and whether you participate in employer-sponsored retirement saving plans.
The IRS has extensively dictated to what extent your contributions are deductible depending on if you are part of an employer-sponsored investment saving plan. Additionally, in each case, your deductions also depend on your annual income and whether you file your taxes jointly, individually, or as the head of a household.
Can You Transfer Funds From a 401(k) to a Traditional IRA?
Yes, you can transfer your 401(k) funds to a traditional IRA account. All you have to do is find the right custodian to start your traditional IRA and move your money.Dorado allows you to fund your IRA account by easily transferring your available 401(k) funds.
Transferring from a 401(k) to a Traditional IRA keeps you under the same tax treatment, as both the accounts let you make tax-deductible contributions. With Dorado, the transfer is hassle-free and quick.
What’s Better: A 401(k) or a Traditional IRA?
While both accounts have their benefits, the best option ultimately depends on your individual situation. If your employer matches your 401(k) contributions, then a 401(k) might provide better returns and further increase the power of compounding.
However, 401(k)s typically provide less autonomy, and you can no longer contribute to them if you lose or quit your job. Additionally, only certain employers allow you to invest your 401(k) funds in alternative asset classes like crypto to improve your diversification.
Traditional IRAs and especially SDIRAs, on the other hand, offer a much larger amount of flexibility.With traditional IRAs,you are no longer restricted by your employer’s terms and conditions.
If you have confidence in your investment decisions and a fair understanding of the crypto landscape, Dorado is a perfect mechanism to add crypto to your retirement savings — either through a traditional SDIRA or a 401(k).
If you are interested in growing your money in a tax-efficient manner through the power of crypto, consider signing up to Dorado.