IRAs and 401ks – What’s the Difference?
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.
Can you pay into both a 401k and an IRA?
Jeff – Thanks for your question. The simple answer is ‘yes’, as long as you don’t exceed the contribution limits. Indeed, some experts recommend saving into a combination of 401k and IRA plans in order to build up the best retirement savings fund for you.
Thank you very much for explaining many details about 401ks and IRAs very concisely and effectively. I am trying to do some research into IRAs to expand my savings beyond my company’s 401k program. The 401k calculator was VERY helpful and interesting to help me get a grasp on what my savings will look like in 35 years when I retire. Thanks for providing the information!
Just to be clear on your answer to Jeff R, I can contribute $17,000 to my 401(K) and $5,000 to an IRA for a total of $22,000 in the tax year. Can my wife also contribute $17,000 to her 401(K) and $5,000 to an IRA in the same tax year giving us a combined deferred contribution of $44,000 for the year?
I sure would like an answer to Bill A’s question from Sept. 19, 2012 — can he contribute $17,000 to his 401(k) AND $5,000 to his IRA — a total contribution of $22,000 in the same year?
My understanding is that investment caps are for the individual not the household, so the husband could invest his $17,000 and the wife her $17,000.
S.O.S.
Homeowner and an independent 40 yr. old female, who has lost employment. I have feverishly sought to regain employment, maintain shelter, food, and heat. Unfortunately, I’ve generated minimal gains in all cited areas. NOW, I am lose my home.
Currently, I have no source of income. With my previous employer, I held and continue to hold a 401 K (Fidelity). Due to my level of financial hardship, I would like to utilize monies from my 401K.
Regarding optimum utilization options; I have consulted with Fidelity but I continue to be unsure and confused.
Possible options:
*If permitted, loan against my 401K?
*Cash out my 401K?
*Roll over 401K into a Roth IRA?
If I am able to ‘somewhat’ comfortably tap into my 401K, I would prefer financial distribution to be spread out and not provided in a lump sum.
Any feedback, comments or links would be greatly appreciated.