At their core, the 401(k) and the IRA are both tools investors use to make money with their money. But there are crucial differences in how they work that are important to understand. The most significant difference is that many 401(k) plans require an employee contribution, varying from 1% all the way up to 25% of the employee’s income (the IRS has a handy calculator for this). There are also differences in contribution limits and the ability to determine your own investments.
What is a 401(k) plan?
Most of us are familiar with 401(k) plans—they’re big news on Wall Street. But just because something is big and complicated doesn’t mean it’s beyond understanding.
The name “401(k) plan” comes from the fact that the portion of the Internal Revenue Service code covering these plans is the section 401(k). A 401(k) plan is a type of investment account. You can think of it as a set of two pots: one is your retirement pot, the other is your tax-deferred pot.
That second pot might grow unhindered by taxes in some cases. The government provides incentives, such as tax breaks and free matching contributions, to make 401(k) plans very attractive. Through payroll deduction, an employee may elect to contribute pre-tax income to the 401(k) plan.
The most significant benefit, especially in the early years of a 401(k) plan, is an opportunity for employees to save on taxes. If you have your contributions deducted from paychecks before income taxes are taken out, you’re essentially getting a huge tax deduction that you wouldn’t get otherwise. In this case, you will not deduct the contribution from your taxes if your employer contributes to a workplace 401(k) plan on your behalf since the contribution will be coming directly from your income.
What is a 401(k) rollover?
A 401(k) rollover is a strategy for moving your 401(k) into another qualified plan without having to pay taxes or early withdrawal penalties. (You may also hear this financial transaction referred to as a “transfer.”) This kind of rollover is not to be confused with the internal transfer of funds from one account in a single plan to another. Internal transfers do not have tax consequences, although they do trigger a taxable event for your investment balance. A 401(k) rollover is an investment that boosts your retirement funds.
A 401(k) rollover is an option you have after leaving a job. If you’ve ever worked for a company and had a 401(k) retirement plan, rolling over a 401(k) is simple and lets you take control of your money. With a 401(k) rollover, you move your 401(k) balance from one account to another. For example, you can transfer the balance from your old 401(k) to an Individual Retirement Account (IRA).
How do I access My 401(k)?
Many people don’t realize it, but you have a few different options for accessing your 401(k). While it’s generally possible to withdraw money early, that’s not the smartest approach. There are two main methods of accessing 401(k) balances.
The first is to roll over the account balance into an IRA (individual retirement account) and then withdraw from that new retirement fund upon retirement or job change. The second method is to leave the account where it is and make payments directly from it.
You are protected under the law, and these accounts are insured. They allow for long-term growth, tax savings, and you have the option to invest in company stocks. You should enroll if you qualify for a 401(k).
If the entire plan sounds like gibberish to you, it might just be time to switch to more direct control of your investments and go with Individual Retirement Accounts. They’re less risky than company stock, so it’s easier to put all your eggs in one basket.
What is an Individual Retirement Account (IRA)?
An Individual Retirement Account (IRA) is a personal account used for saving for retirement. It can be a valuable tool to help you reach your saving goals and is a tax-advantaged way to save for retirement, and is available even if you don’t have a company to sponsor a 401(k).
For people under age 50, you can contribute up to $6,000 per year to your IRA, and your contribution will be tax-deductible. If you are 50 or over, you can contribute up to $7,000 per year.
Is an IRA or 401(k) right for me?
The 401(k) is an employer-sponsored retirement account, whereas the IRA is an individual account.
The choice of retirement account will depend on individual circumstances. It might involve comparing personal situations, an analysis of available options, and concerns such as taxation, future earnings, and risk management. If both types of accounts are available and sound appealing to you, you can have both at the same time.
Both a 401(k) and an IRA are tax-advantaged ways to save for retirement. Both are meant to help you build a nest egg. The 401(k) has higher contribution limits than the IRA, but the IRA may be more flexible in allowing you to choose which investments go into your account. Before choosing between the two, ask yourself how much money you can contribute, whether your workplace offers matching contributions, and how easily you can afford the lost salary payments during retirement.
Final thoughts
Everyone needs to save money for their retirement in some way. There are many similarities between these two account types and the underlying investment principles, but there are also a few key differences.
In short, governments and companies offer 401(k) plans to attract and retain talented workers because they provide tax benefits for employers and employees alike. The IRA is an individual account that may be more self-directed, but has lower contribution limits. There are several types of both 401(k)s and IRAs.
The myriad types of 401(k)s and IRAs extend beyond the scope of this article; however, it is essential to know that there are some distinct differences between these two products worth considering before you decide which type of account makes the most sense for you (and maybe the answer is both).
