IRA vs 401k What’s the Difference?

An IRA and a 401(k) are both retirement programs. The main difference in an IRA vs 401k is that an IRA is an Individual Retirement Account, meaning an individual is solely responsible for opening it, paying into it and controlling the investments in it. A 401(k) is a retirement program set up by an employer.

Contributions: IRA vs 401k

In a 401(k) program, the employee contributes tax-free money. The majority of employers that offer a 401(k) will also help contribute to it. This is essentially free money and should be taken advantage of by every employee. Employers can choose the amount they contribute, which is typically $.50 for every $1.00 the employee contributes, up to a certain percentage of the employee’s annual salary. Some employers will match the employee’s contribution dollar for dollar. This is the easiest way to double your retirement savings. The cap for 2012 contributions has been increased to $17,000 ($16,500 in 2011).

Keep in mind, however, that many employers will require the employee to work for them for a set number of years before they are allowed to keep the employer matched contributions. This is called being vested in the company. Once the employee is fully vested, they are entitled to 100 percent of the employer matched contribution. If the employee resigns or is terminated before they are fully vested, they can lose the money the employer contributed to their 401(k). It is important for an employee to discuss vesting with the human resource department so they are well aware of the guidelines used by the employer in contributing to the 401(k), as well as the details of the vesting period, if applicable.  With IRAs, there is no such thing as vesting.  The money you contribute to an IRA is considered yours from the start.

Withdrawals: IRA vs 401k

Withdrawals from a 401(k) should not be made until the individual reaches age 59½ in order to avoid paying stiff penalties. Withdrawals must begin by age 70½. Contributions made up to age 59½ have great tax benefits – the contributions are tax deductible, while the investment growth of the account is tax-deferred. If money is withdrawn before age 59½ it will be assessed an early distribution penalty tax in addition to being taxed as ordinary income. The few early withdrawal exceptions include:

•   If the individual dies and the account is paid to a beneficiary
•   If the individual becomes disabled
•   If an amount less than is allowable as a medical expense deduction is withdrawn
•   If the individual begins substantially equal periodic payments
•   If the withdrawal is related to a QDRO – a Qualified Domestic Relations Order

IRA Details: Contributions and Distributions

An IRA is a retirement account that is opened by an individual with the help of a financial institution such as Fidelity, Vanguard or T. Rowe Price. Investment brokers can assist an individual in opening an IRA and explain the different ways to invest the money that is contributed.

The individual that opens the IRA controls where the money is invested – although most people rely on the expertise of their financial broker to assist to make this decision. The money invested in an IRA can be distributed in stocks, bonds, mutual funds or Certificates of Deposit. These investment choices provide you with different levels of security, stability and investment return.

Roth IRA contribution limits for 2012 are $5,000 for those under age 50 and $6,000 for those over age 50. However, contribution limits can vary according to an individual’s tax filing status and income level.

The Roth IRA has a tax break like no other investment tool. If you keep your funds in your Roth for a minimum of five years and do not make a withdrawal until after age 59½, none of your withdrawals will be taxable. Just like with 401(k), there are early withdrawal penalties – similar exceptions include:

•   If you become disabled
•   If you need to pay for higher education costs
•   If you need money for a first time home purchase
•   If you need to pay large medical expenses

The choice of an IRA vs 401k can be a good question if an individual is employed and their employee offers a 401(k). The employee should take advantage of the 401(k) first and invest any additional money in an IRA.

Do you have both an IRA and 401k? Was this explanation helpful?