What are the differences between a 401K and an IRA?
A traditional IRA and 401(k) are similar in terms of how they are treated for taxes. The main differences are contribution limits, access to funds, and eligibility.
Both the IRA and 401(k) are retirement accounts and the IRS provides special tax benefits for money contributed and held in these respective account types. Funds invested in both will grow tax deferred, and typically investors receive an income tax deduction for the tax year in which they make contributions. Your ability to receive a tax deduction for contributions to an IRA depends on your tax situation, here is information about deductions for IRA contributions from the IRS.
You can contribute more to a 401(k) each year than you can to an IRA and you can contribute to both in any given year. Furthermore, if you are over the age of 50, you can make additional “catch up contributions”. Below are the 2016/2017 annual personal contribution limits published by the IRS:
|With Age 50+ Catch Up||$6,500||$24,000|
If you withdraw funds from an IRA or 401(k) before age 59 ½, the IRS will assess a 10% tax penalty in addition to income taxes owed on the funds disbursed. Some 401(k) plans may offer loans, which allows you to access a portion of your 401(k) account in the form of a loan, which you are expected to pay back to yourself. If you don’t pay it back, it will be considered a withdrawal and you may be subject to the early withdrawal penalty based on your age at the time of taking the loan. IRA accounts do not allow loans.
The key factor of being able to contribute to a 401(k) is having access to one. Anyone can setup an IRA for themselves, but a 401(k) is a group retirement plan setup by an employer. If you are an entrepreneur or a small business owner, your business can setup a plan for you. If you are an employee, it would be up to your employer group to offer a 401(k) plan.
There are many other differences in terms of maintaining a 401(k) which is subject to ERISA and entails all sorts of additional reporting, testing, and compliance each year. An IRA is much more simple to setup and does not involve any of this additional reporting or annual administration.
Some of the main differences are:
- A 401(k) plan is an employer-sponsored plan therefore you must work for the company in order to participate in the 401(k). In most cases anyone under the age of 70.5 who earns income can participate in an IRA.
- The 401(k) plan usually has better creditor protection than an IRA since it is an employer-sponsored investment plan.
- 401(k) plan contributions are usually made through payroll deductions. An IRA contributions usually are done by the individual writing the check and depositing in the IRA.
- A 401(k) Plan can offer loan privileges. An IRA does not have loan privileges.
- A 401(k) Plan can have an employer match provision. An IRA does not
- Contribution amounts are higher for a 401(k) ($18K for 2017). An IRA has a contribution amount of $5,500 (not including catch up)
- The catch up amount in a 401(k) is $6,000 in 2017. An IRA catch up is $1,000 in 2017.
- The investment options in a 401(k) are usually more limited than an IRA
A 401(k) comes from your employer. Typically, you have to pick investments from a narrow list of choices. The best ones have an employee matching program where the company will match what you put in. Always take the match, it's free money.
An IRA is completely independent. You can open them yourself for free and you can decide from thousands of securities how you would like to invest. Usually when you leave a company, you "rollover" your 401(k) into an IRA.
Both are tax-deferred retirement accounts, meaning you can invest tax-free until you take it out after age 59 1/2.
A 401(k) account is part of an employee's benefit package offered by his/her employer. The employee is able to contribute funds from income and the employer, in many cases, will match a portion. For a traditional 401(k) account, it is tax-deferred, making it similar to an IRA. An IRA, on the other hand, is an account that is separate from the employee's benefit package. It may have been funded by a 401(k) from a previous employer, but the IRA is completely separate from any employer or benefit package. Oftentimes, 401(k) accounts have a limited number of investment selections available. An IRA can have a wide variety of choices depending mainly on the broker-dealer holding the account.
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.
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.