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

401(k), IRAs
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Traditional IRAs, Roth IRAs and 401(k) plans are effective ways to save for retirement. They do have some differences though, so which one you should use for retirement depends on your situation. 

When employers want to give employees a way to save for retirement, they may offer 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. For those who are self-employed, as the owner of the company, they can offer themselves a 401(k) plan. 

Investment Options 

IRA accounts are held by custodians, such as banks or brokerages, which often allow account holders to own many different assets within their IRAs, including stocks, bonds, CDs and even real estate. While 401(k) plans typically offer several fund options to match the different risk tolerances of employees, where the money can be invested is generally more limited than with an IRA. 

Tax Treatment of Contributions 

Any contribution to a 401(k) is tax deductible, regardless of the income level of the investor. Traditional IRA contributions are tax deductible too if the investor’s modified adjustable gross income (MAGI) is under a certain limit. As the limit is approached, the amount of contributions that can be deducted decreases. Deduction limits are also based on federal income tax filing status and whether or not the investor’s employer has a retirement plan at work. 

Roth IRA contributions are not tax deductible, but the assets in the account grow tax free and qualified distributions are not taxed. 

Contribution Limits 

How much an investor can contribute to either type of IRA is much more limited than it is for a 401(k). For 2018, the maximum an investor under 50 can contribute to any IRAs is $5,500. Those over 50 are allowed a catch-up contribution of $1,000, bringing their total to $6,500. Even if an investor has more than one IRA, he or she can only invest up to $5,500 (or $6,500 if over 50) combined. (For related reading, see: Are catch-up contributions tax deductible?

Those under 50 can contribute up to $18,500 each year to a 401(k) plan and can add an extra $6,000 to the amount after age 50, for a total of $24,500 each year. 

Employer Match 

The difference that would most likely sway an investor to fund a 401(k) instead of an IRA is the employer match. When money is invested in a 401(k), at least a portion of it is often matched by the employer. So for every dollar invested, the employee will receive a percentage of that amount in his or her account from the employer. Keep in mind, this is not a requirement, it is up to the employer to decide if and how much they will match. (For related reading, see: What Is a Good 401(k) Match?

Because IRAs are not sponsored by an employer, there is no chance of receiving matching funds. 

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. 

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

For those who have access to a 401(k) through their employer, it is generally recommended to invest enough in it to at least take advantage of any employer matching available. Otherwise, the investor will need to consider their own situation to decide whether a 401(k), IRA or combination of both is best. (For further reading, see: Picking Funding Priorities: 401(k) vs. IRA.)

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