What are the differences between a 401K and an IRA?

By Yolander Prinzel AAA
A:

When employers want to give employees a way to save for retirement, they may offer participation in a 401(k), a retirement plan outlined in IRS tax code section 401(k). They may also offer employees a SEP IRA or, if the company has fewer than 101 employees, a SIMPLE IRA. Individuals can open a ROTH or Traditional IRA separately from an employer, but a 401(k) can only be obtained when offered by an employer which, for the self-employed, includes an owner/employee.

Assets, Contributions and Taxes
IRA accounts are held by custodians, such as banks or brokerages, that can allow account holders to own many different assets within their IRAs, including stocks, bonds, CDs and even real estate. The IRS has stated that some assets, such as art, are not permitted within an IRA. Contributions for Traditional IRAs are tax deductible. Roth IRA contributions are taxed (although the individual's contribution may still qualify for the Saver's Credit) but the assets in the account grow tax-free and qualified distributions are not taxed.

IRA contribution limits are set by the IRS, whereas 401(k) limits are set by the employer. 401(k) contributions are taken from an employee's paychecks on a pre-tax basis, which means that payroll taxes aren't paid on them. Roth 401(k) contributions are taxable but qualified distributions are not. All contributions are deposited directly into the 401(k) account. Employees will be given a choice of funds that they can allocate their contributions to within the 401(k). The funds are set up like mutual funds, in that their underlying investments are collections of stocks, bonds and other assets. The funds are designed to meet a specific risk tolerance so that the employee may only take on as aggressive a risk as he or she is comfortable with.

Loans
An employee may be permitted to take loans or hardship withdrawals from a 401(k). Loan repayments are generally taken from the employee's paycheck.

IRAs do not generally permit loans or penalty-free distributions before age 59.5, but account holders may be permitted to take up to $10,000 without penalty if they are using it to buy their first home.

SEP, Simple and 401(k)
SEP IRAs are fully employer funded, whereas Simple IRAs may have an employee contribution and an employer match. A 401(k) is similar to a Simple in that both the employer and employee can contribute. Generally, within the plan documents, the employer will outline the parameters for any available contribution matches. For example, for every $1,000 an employee contributes, an employer may contribute a matching 50%, up to $1,500. While many employers enjoy offering this incentive, it's not a requirement.

If an employee leaves the company, then he or she may not be entitled to that 401(k) employer match unless he or she has met the employer's vesting requirements. SEPs and Simples are 100% vested as soon as a contribution is made.

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