What are the differences between a 401K and an IRA?
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.
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.
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.
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.
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.)
Great question. There are many differences between the two. Here are just a few:
- 401(k) has higher annual limits. In 2017, you can contribute $18,000 to a 401(k) ($24K if age 50 or older). IRA limit is $5,500 per year or $6,500 if age 50 or older.
- 401(k) plans can have loan provisions where you can borrow money and pay the account back. IRAs do not allow loans. I wrote an article about 401(k) loans that you might find helpful.
- 401(k) plans are funded with a salary reduction through your company payroll. This is known as “pre-tax.” IRAs are funded with your after-tax dollars. Then, if eligible, you can deduct the amount you contributed from your income when you do your taxes.
- 401(k) plans are offered by employers as part of a profit sharing plan. The “401(k)” part is what allows the employee to contribute a portion of his/her own salary (See item 1). A 401(k) can also be funded with matching contributions from the employer. For example, the employer might match each dollar you contribute up to a certain limit. This matching is a very attractive component to a 401(k) plan. If an employer offers matching, you would be hard pressed to come up with a reason not to participate.
- 401(k) plans offer a limited list of investments to choose from. The 401(k) is administered under a trust document for the benefit of employees and the trustees are responsible for selecting the investments to make available within the plan. The 401(k) participant must choose among those offered. An IRA gives the investment decision making to the individual. With and IRA, the investment options are vast compared to a 401(k). For example, in an IRA you can invest in individual stock whereas most 401(k) plans don’t allow this (unless it is company stock).
I just realized I could probably write 5 more pages on this, but will stop here. I wrote an article called Don’t Neglect Your 401(k) Plan that goes into a little more detail about these plans. I hope you find it helpful.
Please note that this should not be considered investment advice and is only educational in nature. Please be sure to consult with your own legal, tax, or investment advisor regarding your specific situation.
Best of luck!
David N. Waldrop, CFP®
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 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.
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.
An IRA and a 401K are similar in many ways. But biggest difference is how much you can contribute.
Here is more information about all the various retirment accounts out there:
The Traditional IRA is the most common type of IRA. You can contribute up to $5500 per year ($6500 if you are 50 or old including the catch-up contribution). Depending on your household income you may be able to deduct your contributions to an IRA, potentially lowering your current tax bill. (There are limits to contributions and deductions see IRS Table below.)
Another benefit of an IRA is you invested will grow on a tax deferred basis, and you will not incur taxes until you start taking money out of the account. This is a retirement account, and funds need to stay in the account until at least 59 ½ to avoid a 10% IRS penalty. Withdrawals will be taxed as regular income once you have reached the ripe old age of 59 ½. With proper tax planning advice the goal would be to pay less taxes on this income in retirement than you would while you are working full time.
401(k) Plans or Profit Sharing Plans
401(K) are the most common for private sector employees. Much like a Traditional IRA your contributions are tax deductible, and your investments will accumulate on a tax deferred basics. Again you should leave you money in the account until you are 59 1/2. Withdrawals will be subject to ordinary income taxes. Plus that pesky 10% penalty for early withdrawals (pre 59 ½). There will also be required minimum distributions from 401(K) plans starting at 70 ½.
There are a few reasons to love 401(K) plans. First off they can be funded right out of your paycheck, which will make it easier to stick to your contributions. Second they have much larger contribution limits. “Maxing Out” you IRA may sound great, but in reality if you are starting late or have above average income (household income above say $50,000) putting way just $5500 per year will most likely leave you taking a big dip in your standard of living during retirement. In 2017 you can contribute up to $18,000 per year to a 401(K) plan. If you are 50 years wise or more you can also make a “catch-up” contribution of up to $6,000. Meaning a potential $24,000 contribution per year each. To make this even better your employer may match some of your contributions, and/or offer a profit sharing contribution.
You can potentially have combined contributions (employee, employer, and any profit sharing) of $54,000 per year. That jumps to $60,000 per year if you have reached 50 years old (2017 numbers). There will often be a vesting schedule for the employer contribution, meaning if you leave your job within a certain period of time you will forfeit some of the matching or profit sharing contributions. With that in mind be aware of when you give notice, you don’t want to quit one day before another vesting deadline. (This may sound obvious but I guarantee you most people forget about this when they overwhelmed with the excitement of their next job.)
Depending on how you look at it a big benefit or big drawback of a 401(K) plan is the limited investment options. You may get stuck with some crappy investment options, or the plan may not have a great array of choices. For some the limited choices may make getting started easier, other may grumble about being limited to a select group of investments, or not being able to utilize their favorite investment selections. In the grand scheme of things I’m pretty ambivalent on this point, I’d rather get a generous company match and good investment options, than amazing options with no match, or the lower contribution limits of a traditional IRA.
Live for Today, Plan for Tomorrow.
DAVID RAE, CFP®, AIF® is a Los Angeles-based financial planner with DRM Wealth Management, a regular contributor to Advocate Magazine, Huffington Post, Investopedia not to mention numerous TV appearances. He helps smart people across the USA get on track for their financial goals. For more information visit his website at www.davidraefp.com or the Financial Planner LA blog.