IRA vs. 401(k): What’s the Difference?


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IRA vs. 401(k): What’s the Difference?
IRA vs. 401(k): What’s the Difference?



The most important financial goal we can achieve in life is saving for retirement, and Americans have several optionsfor retirement savings. However, the two most popular choices are Individual Retirement Account (IRA) and 401(k). Whether it's an IRA you've established asan individual or 401(k) set up by your employer, these benefits will cater to your golden years.

As an employer, you may contribute to a defined contribution such as 401(k) for your employees. In such an arrangement, employees contribute a fraction of their overall compensation to their 401(k),while the employer matches the amount up to a pre-determined limit. Additionally,the employer can offer a Savings Incentive Match Plan for Employees (SIMPLE) or Simplified Employee Pension if the company has less than 100 employees.

You can choose your own savings method through an IRA as an individual. However,the employer will not match your contributions in such an arrangement. Different types of IRAs have different tax advantages and contribution limits. Both retirement accounts grow tax-free, but the withdrawals are taxed at the tax rate of the income received during retirement.

That said, most 401(k) and IRAs do not offer withdrawals before the employee reaches 59 and Half Years. However, in the case of withdrawals Internal Revenue Service (IRS) levies a tax penalty unless thereare exceptions.

What are the differences between an IRA and a 401(k)?

1.    Mode of Contribution

In IRA, the employee opens the account unless it is Simplified Incentive Match for Employees (SIMPLE) IRA or Simplified Employee Pension (SEP). In SIMPLE and SEP, the business owner can open and fund the account on behalf of the employees.

In 401(k), the employers set up the accounton behalf of the employee. As with most savings accounts, it operates under Employee Retirement Income Security Act (ERISA). This Act stipulates the minimum standards for private-sector retirement plans.  

The tax advantages and withdrawal rules vary in both plans depending on the type of account. However, if you withdraw from any of them before the age of 59 and Half years, you are charged a penalty of 10%. Contributions in the significant type of IRAs are as follows:

Roth IRA: In Roth IRA, you contribute from taxed income; withdrawals are not taxable, but if you incur a penalty for early withdrawals.

Traditional IRA: In this account, your contribution is tax-deductible, and your money grows tax-free but taxed during withdrawal. However, all the above depends on your tax status, income, and if your employer covers your retirement account.

In traditional 401(k), as the employee, you get a tax break on the portion you contribute from your income taxed during distribution. However, as of 2020, almost all 401(k)s allow employee contributions from taxed income and tax-free withdrawals if you've held the account for five years and above and are 59 and half years and above. Nevertheless, the employer’s contributions aresaved on a different account and taxable during distribution.

2.    Plan Limits

In 2022, the IRA contribution (Traditional and Roth) limit is $6,000 for persons below 50 years. Persons above 50 years are allowed to contribute an extra $1,000 each year. However, your contributions can only be from your annual income. If you made $3,000 in 2022, you are only eligible to contribute a maximum of $3,000.

In 401(k), the maximum contribution in 2022 is $20,500 for employees below 50 years. Employees above 50 years are currently allowed $6,500 per annum as a catch-up contribution. Regardless of the above allowances, the total contribution for the employee and employer should not exceed the employee's 100% income or $61,000. However, the above limit does notinclude the catch-up contribution of $6,500.

3.    Eligibility

The employer can set the other terms to contribute to a 401(k), other than the 21 years age limit and a minimum of one year of service. However, the employer should ensure the rules are not excessively restrictive.

On the other hand, to contribute to an IRA, you must have earned an income either as a bonus, wages, tips, salary, or self-employment income. Incomes such as annuities, unemployment benefits, pensions, annuities, and security benefits do not count as earned income. If you also file joint tax with your spouse, you can contribute to an IRA regardless of whether you have no or little earned income in Spousal IRA.

Which Plan is Right for You?

Whether youhave an IRA or a 401(k), the right one for you depends on the desirablefeatures. A 401(k) may allow more savings, and it is also easier to manage, butit has limited investment choices. On the other hand, an IRA has moreinvestment options if set up with an investment company or a broker. Again, anIRA allows you to manage your investments and hold the retirement savings in anIRA savings account which is not allowable in most 401(K) plans.