Small Business Realities: What's the Difference Between a 401k and an IRA?

This is one of those questions that pops up routinely. The answer is most important for those of you who own your own business, but it crops up for those who work in small companies, too. So what is the difference between a 401k and an IRA? Well, it comes down to a matter of trust—trust accounts, to be exact.

IRA's are really cheap and flexible

An IRA or "Individual Retirement Arrangement" is just what it sounds like. The account is fully owned and controlled by you, the person who hopes to retire one day. The IRS Tax Code says that, as long as you follow their rules with your "arrangement," they won't ask you to pay income or capital taxes on the money you put in your account until you start taking it out (for more about tax deferral and why it's so great, check "Making Sense of Your Company's Retirement Plan"). The rules here are fairly simple: you need to put the money in a trust for your own benefit. Of course, there are some details, but the banks and brokerage houses have stepped in to cover you there. You can open an IRA account at any average bank or anywhere you would open an investment or stock trading account. And in many cases, it costs nothing to open one. Here is Investopedia's list of no or low-balance IRA account offerings for 2015.

Because the IRS doesn't put many limits on what can go into an IRA account, you can invest in all sorts of things with your retirement money. So, when you do go to choose the bank or broker for your account, check their offerings and ask about things like account management fees or trading fees. We often use different brokerage houses for someone who wants to "sit on" three or four standard index funds as opposed to someone who will be doing more trading.

Use the IRA for you business

Believe it or not, your business can open IRA accounts for your employees instead of a 401k plan. Called a SIMPLE (Savings Incentive Match Plan for Employees), these accounts let you, the employer, contribute money to your employee's IRA accounts without the hassle of a 401k. Cheap, easy and available to any business with less than 100 employees (and no other retirement plan), the SIMPLE only requires you to choose a fixed amount to contribute to your employee's plans—either 2% of her salary each year or a "match" of what she contributes between 1% and 3% of her salary.

The IRA compromise

There is a catch. If you are an ambitious saver, IRA contribution limits might mean that you can't put as much into your account as you like. For 2015 and 2016, your total contributions to both your IRA and Roth IRA can't be more than $5,500 for the year ($6,500 if you are over 55). BUT, if you are contributing to an IRA through your employer's SIMPLE plan, that limit goes up to $12,500 (or $15,500 if you're over 55) per year for 2015 and 2016—and that doesn't include your employer's contribution.

The Great 401k

There are a lot of smaller companies out there that would probably do better with a SIMPLE, but the fact is that 401k's, a type of qualified profit-sharing plan, dominate the U.S. workplace. And there are some good reasons for that. Like the IRA, the 401k is a form of trust account that follows rules laid out in the IRS code  in exchange for tax deferrals.

In this case, though, the rules are more complex and the employer retains a lot more control over what's offered in the plan. And that means some serious compromises for both the employer and the employee.

Employees can only invest their 401k money in what's offered in their employer's plan. If your employer has done a great job sourcing a plan, that should be fine for most people. Historically, though, we've seen a lot of 401k plans that offer expensive and/or limited investments and include high management fees. That leaves employees with a less effective account that can add up to tens of thousands of missing dollars over the course of a career.

Employers also often struggle with their 401k plans. As the employer, you have a fiduciary duty to ensure that the plan is fair and well-managed for your employees. And you have a more complex set of filing requirements so that the government can make sure you are taking that duty seriously. For this reason, it has often been difficult for smaller companies to get a good, reasonably priced 401k plan. Keep in mind that the fees will generally include someone to manage the investments and someone to manage the plan to keep you out of trouble.

Why We Love 401k's

Despite the complexity of 401k's, they remain a favorite even amongst smaller companies. Some of this is just down to the enthusiastic efforts of brokerage houses to sell these plans. But there is a real advantage to the 401k, as well. While the SIMPLE limits employees' contributions to $12,500 ($15,500 if she is over 55), employees can contribute a lot more to a 401k account—up to $18,000 per year for 2015 and 2016 ($24,000 if she is over 55). That extra can mean a lot to the right employee.

The Conclusion

So, which sort of plan works better? As you might expect, it all comes down to the size of the business and the savings ambitions of the employees. If you are an employer, it pays to look at your options. If you go with the 401k, be finicky about the brokerage house or investment advisor you choose—choosing the wrong one can cost you and your employees a lot. And if you are an employee in a small business, don't hesitate to approach your employer if you think there's room for improvement. Most employers don't know any more than you do about retirement plan options and are happy to get better information (especially as it might save her some money, as well!).

If you have more questions about small business retirement plans, send me an email.