401(k) vs IRA – What’s the Difference?

401(k) and IRA plans are two of the most common retirement investment vehicles. Each allows you to reduce current income for tax purposes through annual contributions, and both allow for tax deferred accumulation of investment income. But each plan is unique, and offers options and opportunities that the other doesn’t.

401(k)

A 401(k) is a qualified retirement plan that allows participants to contribute a portion of their income and invest it for future retirement. Not only are the contributions deductible from income in the year made, but investment income earned in the plan also accumulates on a tax deferred basis. This provides a way to both reduce current tax liability and allow for faster accumulation of investment assets for retirement.

401(k) plans are generally sponsored by an employer, though it is possible for a self-employed person to set up a plan for a small business as well.

An employee is eligible to participate in a plan that is offered by his or her employer. In general, there are no limits on how much income you can earn in order to qualify for a 401(k), though there is special consideration for employees determined to be “highly compensated employees”.

Contributions are limited to the amount of income an employee earns at the sponsoring employer, but there are no percentage limits with regard to that income. An employer may however impose percentage of income limits, or limit the dollar amount of contributions to some level below the IRS allowed maximums. Contributions can be made up to age 70 ½. Contribution limits are much more generous than they are for IRAs, and are listed in the chart below.

An employee can begin making penalty-free withdrawals from a 401(k) as early as age 59 ½, and must begin taking them no later than age 70½, otherwise penalties will be imposed.

Plans often have loan provisions, allowing participants to borrow against their accounts for various purposes.

IRA

An Individual Retirement Account, or IRA, is a qualified retirement plan that is established and maintained by an individual, rather than an employer. The individual can be self-employed, employed by a company that has no retirement plan, or even by an employer with a plan (in which case contribution tax deductibility may be limited – see chart below).

Like a 401(k), IRAs allow tax deferrals on plan contributions made and investment income earned in the plan by that individual. Withdrawals from the plan are taxable as income when taken.

IRAs typically offer more investment choices. Since 401(k)’s are administered by an employer, they generally offer very limited investment selection – such as one growth fund, one income fund, a money market fund, and company stock. Since IRAs are invested with brokerage firms, the options are much wider. You can generally invest in most investment options the broker has available.

Unlike 401(k) plans, IRAs allow you to take hardship withdrawals penalty free. Hardships can include excess medical expenses, health insurance during times of disability or unemployment, the down payment on a first home, qualified education expenses, total and permanent disability, or distributions made as part of an annuity (see the chart below for more detail).

Using Both a 401(k) and an IRA to Maximize Contributions

Even though you are covered by a 401(k) plan through your employer – and allowed contributions are more generous than for an IRA – you may still want to add an IRA to mix. Consider the following:

  • As noted above, IRAs provide wider investment options than 401(k)’s do
  • Your employer may restrict contributions to an amount well below the IRS maximum – an IRA will allow you to increase your retirement provisions
  • If you are below certain income limits (see chart below) you may get a full tax deduction for an IRA, even though you are covered by an employer plan
  • An IRA represents a retirement diversification beyond your 401(k)

The combination of both a 401(k) and an IRA can allow for both greater income tax deferral and faster accumulation of retirement assets.

401(k) and IRA Comparison Chart

 

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401(k)

IRA

General description An employer sponsored, qualified retirement plan that allows for tax deferrals on plan contributions made and investment income earned in the plan by an employee; withdrawals from the plan are taxable as income when taken A qualified retirement plan maintained by an individual that allows for tax deferrals on plan contributions made and investment income earned in the plan by that individual; withdrawals from the plan are taxable as income when taken
Plan Sponsor Employer Individual
Who is eligible? Any employee of any organization that has a 401(k) plan available to its employees Anyone with earned income, but income limits apply for tax deductibility (see Income Limits below)
Contribution limits For 2013: up to $17,500 per person up to age 49; up to $23,000 per person for age 50 and over; spouse can make equal contributions; Employer can provide matching contribution but the total of both the employee and employer contributions can not exceed $51,000 (maximum contribution to all retirement accounts on your behalf), or the employees total income: An employer can place limits on contributions to the plan that are lower than the IRS limits For 2013: up to $5,500 per person up to age 49; up to $6,500 per person for age 50 and over; spouse can make equal contributions; Since it is an individual plan, there is no employer matching contribution
Income limits There are generally no income limits, but contributions cannot exceed employee’s income earned through the sponsoring employer Can take the full deduction at any income level, but tax deductibility of contributions limited or fully eliminated if owner or spouse is covered by an employer retirement plan, though investment earnings will accumulate on a tax deferred basis; Income limits for 2013:

  • Single, Head of Household – begins phasing out at $59,000, and disappears at $69,000
  • Married Filing Joint or Qualifying Widow(er) – begins phasing out at $95,000, and disappears at $115,000
  • Married Filing Separate – disappears at $10,000

Contribution is limited to earned income

Contribution age limit 70 ½ 70 ½
Age of Required Minimum Distributions (RMDs) Distributions must begin no later than age 70 ½ Same
Investment options Limited to investment options included in employer plan – generally mutual funds; often allows for the purchase of employer company stock Most any investment vehicle offered by the brokerage account the plan is held in; this can include stocks, bonds, mutual funds, exchange traded funds, certificates of deposit, and even real estate and gold (both with certain restrictions)
Investment income consideration Investment income accumulates on a tax deferred basis until withdrawal, at which time it becomes taxable, and is added to owners total income Same
Conversion options Can be rolled over into an IRA upon termination of employment, with no penalties or income tax consequences; Can be rolled over into a Roth IRA, the amount of the roll-over will be taxable for the year it is made Can be rolled over into a Roth IRA, but the amount of the roll-over will be taxable for the year it is made, though no penalty will apply
Age at which withdrawals can begin without penalty 59 ½ 59 ½
Early withdrawal penalties Withdrawals taken prior to age 59 ½ are added to income and taxable, and a 10% penalty is due on the amount of the withdrawal; exceptions apply Same, except that contributions made that were not tax deductible when made are not required to be added to income
Early withdrawal penalty exceptions Can withdraw for certain hardships, but 10% penalty still applies (includes medical, down payment and education expenses) Medical expenses paid in excess of 7.5% of adjusted gross income (AGI), 2) medical insurance premiums paid during disability or unemployment, 3) up to $10,000 for the down payment on a first time house purchase (there are limitations), 4) qualified education expenses paid for self and dependents, 5) total and permanent disability, and 6) the distributions are made as part of a regular annuity – in each case the penalty is waived, but the withdrawals are subject to income tax in the year taken
Roll over provisions Can rollover account to another employer plan, or to an IRA, without being subject to income tax or early withdrawal penalty Account can be transferred to an IRA account at a different institution; transfers without tax liability or penalty if funds are rolled over within 60 of withdrawal
Loan provisions Subject to IRS and employer plan rules – Loans not repaid prior to employee termination are considered distributions, subject to the 10% early withdrawal penalty, as well as inclusion in current income and subject to income tax Not available

(Sources: IRS 401(k) Resource Guide – Plan Participants – Limitation on Elective Deferrals, and IRS Publication 590 – Traditional IRAs)

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