What's the Difference Between a 401(k) & IRA?

Key Takeaways

• IRAs are available to anyone with income from work at any age, providing flexibility in investment options. Contributions are owned solely by the individual, and the annual contribution limit for traditional IRAs is $7,000 (or $8,000 for those aged 50+).
• 401(k)s are available through employers and have higher contribution limits, up to $23,000 per year (or $30,500 for those aged 50+). Some plans offer employer matching and allow loans, with a total annual savings limit of up to $58,000.
• Both IRAs and 401(k)s offer tax advantages, with contributions being tax-deductible, but withdrawals are taxed as ordinary income. Roth options allow tax-free withdrawals in retirement.
• IRAs can be contributed to until the tax-filing deadline, with no age limit for contributions. 401(k) contributions must be made by the end of the calendar year and are accessible through employer-sponsored plans only.

Are you considering opening an individual retirement account (IRA) to either replace or supplement your employer-sponsored plan? If so, it can help to know the difference between 401(k) and IRA plans. The good news is that these differences are fairly easy to understand.

What Are an IRA's Unique Features?

Anybody who has an income from work at any age can set up and save money in a traditional IRAs, which are owned only by the contributing individual and not an employer. How you invest the money you put in an IRA is up to you, meaning you can be as aggressive or conservative as you want. You can also open an IRA with most kinds of financial services companies, including life insurance companies, banks and brokerage firms.

Traditional IRAs have a $7,000 limit (or $8,000 for people 50 and older) on annual contributions.¹ Your contributions may be tax-deductible. The deduction may be limited if you or your spouse is covered by a retirement plan at work and your income exceeds certain levels. But there's no income test for IRA contribution deductibility if you don't have access to a retirement plan at work.

You can make contributions for each year as late as the tax-filing deadline for that year's taxes. Contributions can be made to your traditional IRA for each year that you receive compensation, no matter what age.

If you take any distribution from your IRA before you turn 59 1/2, the IRS will charge you a 10% penalty. There are some exceptions to this rule, such as if you need to pay for medical expenses that exceed 10 percent of your gross income and are not covered by a health plan.²

How Is a 401(k) Different?

Unlike an IRA, a 401(k) is only available through an employer. Although they are very common, employers aren't required to offer them. They allow you to set aside much more of your own earnings - up to $23,000 a year, or $30,500 if you're at least 50 - than you could in an IRA account.³ Some 401(k)s feature matching employer contributions, which employers sometimes base off the amount each employee contributes.  

Some 401(k)s also have loan provisions that would allow you to borrow money from your own account and pay it back with interest, usually within five years. You may owe taxes on any money you borrow, and the IRS limits these loans to $50,000 or half of your vested balance (whichever is smaller).

The plans allow for as much as $58,000 in total annual savings in your account, counting both your contributions from your own income and any extra money your employer puts in. The deadline for annual contributions to a 401(k) plan is December 31, compared to the tax-filing deadline that applies to IRAs.

A feature of both traditional 401(k) and IRA retirement plans is that when you begin taking money out, it's all taxed as ordinary income, even if some of your retirement savings actually came from capital gains, or the increase in the value of the contributions. (With investments outside of a retirement plan, capital gains are usually taxed at a lower rate.) As with any investment, however, increases in value are not guaranteed, and there's always a chance of losing value. Still, with 401(k)s and IRAs, you may have the option to postpone your tax bill until you start taking money out (depending on your plan's documentation).

Making Sense of the Roth Option

There's another category of IRA and 401(k) known as Roth plans. With Roth retirement accounts, you pay taxes on your contributions as you make them. You don't take a tax deduction for the money you put into a Roth plan each year, but the contributions you make can be taken out at retirement without being subject to income tax, since you've already paid. (You must have had the Roth account for at least ten years, though).

If you're eligible to participate in a 401(k) plan and your employer makes matching contributions, you might consider contributing enough to be eligible for the full match. If your employer's plan doesn't offer the investment choices you're looking for, however, you could always consider looking for an IRA better suited to your personal financial goals. You could also consider meeting with a qualified financial adviser to help determine whether an IRA, a 401(k) or a balance of both plan types will fit best into your overall financial strategy.

Sources

1. Retirement topics: Contributions. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-contributions.
2. Retirement Topics - Exceptions to Tax on Early Distributions. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions.
3. Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits.