401(k) vs. IRA: An Overview

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 (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 a 401(k), SEP IRA, or SIMPLE IRA can only be obtained when offered by an employer, which, for the self-employed, includes an owner/employee.

Key Takeaways

  • 401(k) plans and IRAs are tax-deferred retirement savings accounts offered by employers.
  • There are differences in which employers qualify to offer each, as well as in contribution limits and investment options.
  • SEP and SIMPLE IRAs are available to some employers.
  • An employer match is one of the most valuable features available.

401(k)

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

Contributions to 401(k) accounts are made pre-tax. The money is deposited in various investments, as selected by the sponsor, and the investment income accrues and compounds tax-free. Withdrawals are taxed at the normal tax rate, as long as they are made after age 59½. 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.

As of 2019, participants can contribute up to $19,000 per year, 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 taken from the employee's paycheck.

IRA Accounts

An individual retirement account (IRA) is a tax-deferred retirement savings account established by an individual person or offered by employers to their employees. They are similar to 401(k) accounts in many ways, but there are some differences.

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 to traditional IRAs are tax deductible.

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

IRAs do not generally permit loans or penalty-free distributions before age 59½, 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 IRAs take a portion of your salary that your employer funnels to the SEP IRA without your intervention—and without any money being contributed by the employer itself. SIMPLE IRAs, on the other hand, may have an employee contribution and an employer match. 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 percent, 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.

Advisor Insight

Michelle Mabry, CFP®, AIF®
Client 1st Advisory Group, Hattiesburg, MS

A 401(k) is an employer-sponsored plan to which you can make elective deferrals. You can contribute up to $19,000 per year, plus a $6,000 catch-up amount for those 50 years of age and over. Employer plans typically provide some amount of matching contribution. You get to select from a menu of mutual funds or ETFs, as outlined by your individual plan. An IRA is not tied to an employer. If your income is below a certain amount and you are not covered by an employer plan, you can contribute up to $6,000 per year plus a $1,000 catch-up contribution for those age 50 and over.

The benefit of an IRA is that your investment choices are much greater and almost unlimited. The costs of each do need to be considered, and will vary depending on the investment selection.