If you’re looking to save your retirement, you’ll probably have come across 401k plans and IRAs (Individual Retirement Accounts). Millions of people save for their retirement through these schemes and they both offer a range of benefits to plan holders.
Here, we look at the main differences between a 401k and an IRA and highlight the advantages of each type of scheme. Keep reading to learn more.
What is a 401k?
A 401(k) is a type of retirement savings account that you can only get through an employer. Contributions to a 401k plan are made directly from your paycheck and, sometimes, your employer also contributes money to your retirement fund on your behalf.
A 401(k) plan is a ‘tax-deferred’ scheme, meaning that you pay taxes when you take the money out, not when you put the money in.
What is an IRA? An IRA is a similar retirement savings account. Your contribution to an IRA each year is generally tax deductible and you aren’t taxed on the income you make as your IRA grows. You pay tax when you withdraw the IRA money for your retirement.
Anyone can open a traditional IRA and you remain in control of the investment – not your employer.
Benefits of 401ks
One of the main advantages of a 401k plan is that the maximum contribution limit for a 401k is higher than an IRA. For 2012, you can put up to $17,000 into a 401(k) plan compared to just $5,000 in an IRA.
Keep in mind that this figure doesn’t take into account any employer-imposed contribution limits. For instance, if your yearly salary is $40,000 and your employer limits your 401(k) contribution to 10 percent of that salary, then your maximum allowable contribution would be $4,000.
A second benefit is that many employers ‘match’ employee contributions to their 401k plan. This is effectively free money that is being deposited in your retirement savings account and it helps to build up your retirement fund.
Thirdly, if you are in desperate need of cash, you can borrow money from your 401k plan and, in some cases, make a hardship withdrawal from the plan. You can’t borrow from your IRA.
Benefits of IRAs
While the contribution limits may be lower on an IRA, they do have some benefits. For example, you will generally have a lot more investment choices with an IRA than with a 401k plan. As 401k plans are often managed by employers, the investment choices may be very limited. An IRA will let you choose from a much broader range of investments and asset classes. And, you can often switch your investments much more regularly.
Of course, the main advantage is that your contributions to an IRA are tax deductible. With an IRA you declare the amount of money you want to pay into your plan by using your tax form 1040. The amount you decide on is then deducted from your taxable income.