401(k) vs. IRA: What's the Difference?

When employers want to give employees a tax-advantaged way to save for retirement, they may offer participation in a 401(k) plan. They may also offer employees a SEP (Simplified Employee Pension) IRA or, if the company has 100 or fewer employees, a SIMPLE (Savings Incentive Match Plan for Employees) IRA.

Individuals can open a Roth or traditional IRA separately from an employer, but only have access to a 401(k), SEP IRA, or SIMPLE IRA when offered by an employer. For the self-employed, "employer" includes an owner/employee. As their names imply, SEP and SIMPLE IRAs were designed to make it easy for employers to set up a retirement plan for employees. They have fewer administrative burdens than 401(k) plans.

In general, you can make withdrawals from 401(k)s and the different types of IRAs penalty free once you reach age 59½, though there are some exceptions.

A 401(k) is a tax-deferred retirement savings account offered by employers to their employees. Employees contribute money to their account and employers can choose to match a percentage of that contribution.

Contributions to 401(k) accounts are made pre-tax. The money is deposited in various investments, typically a line-up of mutual funds, as selected by the sponsor. The fund choices are designed to meet a specific risk tolerance so that employees may only take on as aggressive or conservative a risk with which they are comfortable.

Investment income accrues and compounds tax-free. Withdrawals are taxed at the normal tax rate, as long as they are made at age 59½ or older.

Many employers are also starting to offer Roth 401(k)s. Unlike a traditional 401(k), contributions are funded with after-tax money, so they are not tax deductible; however, qualified withdrawals are tax-free.

As of 2019, participants can contribute up to $19,000 per year to a traditional or Roth 401(k), with an additional $6,000 catch-up contribution allowed for people aged 50 and over.

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

There are several types of IRAs. An individual retirement account (IRA) (traditional or Roth) is a tax-deferred retirement savings account established by an individual person. SEP and SIMPLE IRAs are offered by employers to their employees. They are similar to 401(k) accounts in many ways, but there are some differences, chief among them contribution limits and how they work.

IRA accounts are held by custodians, such as banks or brokerages. Unlike 401(k)s, IRAs allow account holders to own many different assets within the account, including stocks, bonds, CDs, and even real estate. Some assets, such as art, are not permitted within an IRA, according to IRS rules.

Traditional and Roth IRAs

Like 401(k)s, contributions to traditional IRAs are generally tax deductible. Earnings and returns grow tax free and you pay tax on withdrawals in retirement. Contributions to a Roth IRA are made with after-tax dollars, but withdrawals are tax free in retirement.

Annual contribution limits for traditional and Roth IRAs are $6,000, as of 2019, with an additional $1,000 catch-up contribution allowed for people 50 and over.

SEP IRAs

SEP IRAs have higher annual contribution limits than standard IRAs and only your employer can contribute to one. As of 2019, employers can contribute as much as 25% of an employee's gross annual salary as long as the contributions do not exceed $56,000.

SIMPLE IRAs

SIMPLE IRAs contributions work differently than SEP IRAs and 401(k)s. An employer can either match up to 3% of an employee's annual contribution or set up a non-elective 2% contribution of each employee's salary. The latter doesn't require employee contributions.

In 2019, the contribution limit for employees is $13,000 and those 50 and older can make an additional catch-up contribution of up to $3,000.