The IRA and 401k are both types of programs established with the intent of allowing long term tax advantaged savings for your retirement years. They have similarities in how they are taxed, but differences in availability, provisions, and requirements.
What is an IRA plan and 401k Plan
An IRA is an Individual Retirement Account that was first permitted under the Employee Retirement Income Security Act of 1974. The intent of the IRA was to allow individuals not covered under company pension or profit sharing programs to set up an account for their retirement.
The original plan, the Traditional IRA, allowed you to contribute $2,000 into a bank or brokerage account, and take a tax deduction for these contributions on your tax return. In exchange, eventual withdrawals were totally taxable when you retired. Since 1974, the limit on contributions has grown to $5,000 per year ($6,000 if you over age 50 when you make the contribution).
Also, in 1997 Congress passed a bill creating the Roth IRA. This type of IRA allows you to put in after-tax contributions of $5,000, but all withdrawals are totally tax free at retirement or after age 59 ½.
The 401k was designed for companies as an alternative, or an addition, to pension and profit sharing plans. Most large companies initially set up a 401k plan to supplement the existing pension plan. These plans allowed employees to contribute a percentage of salary, usually 3% – 5%, and the company would match all or a portion of the employee contribution.
Both IRA’s and 40k’s became very popular methods of saving and are still the most widely used plans today. Let’s look at some of the primary differences between the two concepts.
Availability of an IRA vs. 401k
The primary difference between and IRA and a 401k is the availability for you to use these types of plans. An IRA is available to all workers who have earned income and are under age 70 ½. While you may be eligible, you may not be able to contribute if your earnings are over certain limits. These limits also change depending upon if you are also covered under a company pension plan.
Another factor which alters the contribution limits is the type of IRA you set up, either Traditional IRA or Roth IRA.
The 401k plan is only available to workers whose employer has established such a plan. Many companies have pension plans and no 401k plans. Alternatively, companies have 401k plans, but no pension plans. So you can’t just go out and join a 401k. You employer must offer this type of plan in their package of employee benefits.
The annual IRA contribution limit for 2011 is $5,000 per year or $6,000 if you are over age 50. This is a relatively small amount if the IRA is you only means of saving for retirement.
The 401k plan allows for much higher contribution maximums. Most corporate 401k plans will allow you to contribute between 1% and 8% of salary. You get the same tax deduction for these contributions as you do under the IRA, and withdrawals are totally taxed when made later on. The company may or may not contribute to the 401k plan. Most large corporate plans will match a portion of your contribution.
This matching program by your employer is essentially free money to you. Some employees do not contribute to a 401k plan since they do not feel they can afford to put in the contribution. However, not contributing is like refusing a salary raise due to you not getting the company matching contribution.
More recently, the 401k rules were changed to also allow companies to set up Roth 401k’s. These are similar to the Roth IRA where contributions are made with after-tax contributions and withdrawals are totally tax free after age 59 ½. Many companies simply let you decide if your contribution to the 401k will be considered Traditional contributions or Roth contributions.
Investment Line Up
Investing in an IRA gives you a lot of flexibility when deciding upon what to invest in. You can choose almost any normal types of investments. There are some limitations on IRA investments, but these are investments that you would not normally put your savings into in the first place.
In the 401k plan, your employer decides what investments will be appropriate to offer employees. These will most times be a selection of mutual funds or individually managed funds. The plan might only give you a choice of 5 or so funds, such as 1or 2 stock funds, a bond fund, a money market fund and a company stock fund. This severely limits your flexibility when investing your money.
Some plans may offer 30 – 40 different mutual funds for you to select from. This gives you more flexibility, but many of the funds still may not meet your investing style.
When thinking of investments, the IRA clearly gives you more flexibility. However, the lack of flexibility is not a reason to stop contribution to a 401k since you might be foregoing the company matching contributions.
Access to Assets
Both the IRA and 401k allow you to stop participating and withdraw your money at any time. Both are subject to similar tax rules when comparing Traditional IRA and Traditional 401k, or Roth IRA and Roth 401k.
The 401k allows you to borrow some of your money out of the plan, without it being a taxable event. Such a loan, however, carries risk. If you spend the money and do not pay back the loan in installments, the entire amount may become taxable. So you may get hit with taxes after you already spent the amount you withdrew.
The IRA has no loan provisions. You cannot borrow against your IRA or use the IRA as collateral for a loan. The only way to get money out is to make an actual withdrawal, and trigger a taxable event.
Using both an IRA and 401k
You might be able to utilize both a 401k and IRA to save for retirement. The decision is based on your salary level, the type of plans you are covered under, and the type of IRA you want to set up.
So Many Different Factors
There are simply too many factors involved with IRA’s and 401k’s to describe in one brief article. It really takes an entire book. These factors include what type of plans you have at work, your salary level, your goals, flexibility needed. All of these then differ if you are considering one of the two main IRA options (see Roth IRA vs. a Traditional IRA for more information).
Suffice it to say that if you have a 401k plan at work, contribute at least the minimum amount to get the full company matching contribution. You can look to see if you can also open an IRA for additional savings.
If you do not have a 401k plan at work, look then to either a Roth or Traditional IRA as your means for retirement saving.