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What Is the Difference Between a 401(k) and an IRA?

People have unique retirement dreams, and there are countless financial ways to achieve them. When looking to invest, some important questions arise. What is the difference between a 401(k) and an IRA? Which investment solution is best-suited to your retirement? These questions are worth exploring, in order to be prepared financially for retirement.

What Is a 401(k)?

The IRS classifies 401(k)s as a form of profit-sharing plan. In other words, these employer-sponsored investment vehicles let employees put away a percentage of their wages to fund their retirements and gain access to key features like:

  • Income-tax exclusion of the money they defer.
  • Ease of contributing without having to think about it or remember to save.
  • Matching contributions from participating employers.
  • Employer tax deductions that encourage companies to participate in funding workers’ retirement savings.

What Is an IRA?

An individual retirement arrangement, also known as an IRA, is a form of self-guided retirement savings plan. Anyone with a taxable income can open their own IRA and do things like:

  • Choosing what they want to invest in.
  • Reducing their tax burdens at the time they contribute to the plan, as with a traditional IRA, or when they withdraw, as with a Roth-type IRA.
  • Selecting from a range of IRA types with different contribution limits.

Retirement Investing By the Numbers

When looking at statistics, it is clear to see how accessible retirement investing can be. Census data suggests that as of 2017, almost 80 percent of Americans worked for employers that offered 401(k) plans. The annual IRA contribution limitations are per-account. In other words, you can save more if you have more IRAs. Although Roth IRAs come with income restrictions, the restrictions are high enough that they only exclude about 10 percent of the population.

Who’s Eligible to Invest?

The only prerequisite for IRA investment is that you have taxable income. With a 401(k), you will also need to find an employer who is willing to participate. Understanding what the difference is between a 401(k) and an IRA takes more than a mere glance. It is important to examine the details closely if you want to save time and make the smartest financial decisions.

What is an IRA or 401k?

Types of IRAs

IRAs come in a few different forms with distinct pros and cons:

What Is a Traditional IRA?

A traditional IRA is a tax-advantaged savings plan that includes:

  • The right to make contributions where the deductibility depends on whether you are covered by an employer retirement scheme and whether your income exceeds a specific limit.
  • The ability to withdraw money at any time.
  • Tax-deferred earnings and gains on investments in the account.

What Is a Roth Individual Retirement Arrangement?

The Roth version of the IRA is unique in that it:

  • Does not let you deduct the contributions you make from your taxes.
  • Allows you receive qualified distributions from the account without paying taxes.
  • Allows you leave money in the IRA for as long as you like without having to take out a minimum withdrawal.
  • Allows you to keep making contributions in your later years.
Difference between 401k and IRA

Types of 401(k) Plans

Like IRAs, 401(k) plans feature various account setups. These distinctions determine how effectively you are able to save and where you can put your capital.

What Is a Traditional 401(k)?

With a traditional 401(k), your contributions come from your payroll before taxes, so you can:

  • Work for an employer that contributes equally to all employees or matches individual account holders’ elective contributions.
  • Enjoy the protection of nondiscrimination requirements governing how employers contribute to specific employees.
  • Choose from schedules that grant you the right to a nonforfeitable employer contribution immediately or after a vesting period, meaning that you may have to wait for a while before you can quit your job and keep the money.

What Is a 401(k) Safe Harbor?

The safe harbor 401(k) has a few essential differences from the traditional variety, including that:

  • Employers must make contributions that are fully vested to the employees at the time of their granting.
  • Employers can be choosier about how they contribute to specific workers.
  • Employers must provide account holders with annual notices regarding the way their plans and contributions work.

Retirement Account Eligibility Basics

One of the most important differences between a 401(k) and an IRA is that they are each geared toward different types of investors. While both cater to members of the workforce, IRAs are for individuals who want to take charge of their retirement funding instead of leaving it up to brokerages.

The regulatory frameworks governing 401(k)s and the need for employer sponsorship make IRAs a bit more flexible in certain regards. Although traditional accounts do not include income limits, Roth plans have phase-out limits at which your maximum allowable contribution starts to decrease.

Another way IRAs are different from 401(k)s lies in the fact that they are more accessible to a broader range of workers. For instance, if you want to try your hand at investing, then an IRA would let you experiment more with your assets. In addition, there are a number of personal financial investment books that focus on improving your knowledge on your options.

IRA compared to 401k

IRAs Compared to 401(k)s: Contributions and Limits

Who can contribute and how much? The answer depends on the type of retirement plan, and the federally mandated limits which change from time to time.

How an IRA Is Different From a 401(k)

With a traditional IRA, the limits are based on your age. As of 2019, those under the age of 50 could contribute $6,000 annually, and those 50 and older could contribute $7,000 per year. The age-based limits were the same for Roth contributions.

Individual contribution limits for 401(k)s are significantly higher than those for IRAs. People under 50 can contribute $19,000 per year, and those older can contribute $25,000.

Catch-up Contributions

Alert investors may wonder about the differences in the contribution limits for each type of plan. These age-based distinctions are designed to help people catch up if they did not invest when they were younger. Although it is usually best to start saving early, putting it off does not mean you have to settle for missing out.

Nonelective Contributions

Some employers contribute to their workers’ retirement accounts even if their workers are not in a saving frame of mind. The nice thing about these nonelective contributions is that they do not come out of your paycheck. They are similar to the regular employer matching that happens with many 401(k)s.

Retirement Saving Tax Implications of 401(k)s vs. IRAs

At what point do you have to pay taxes? Although this is another big difference between a 401(k) and an IRA, it is simpler than it seems:

  • All of your contributions to traditional IRAs happen before taxes, making these accounts tax-deferred. In short, you might get to pay a lower tax rate upon disbursement.
  • Roth individual retirement arrangement contributions take place after you have paid income tax. You do not pay taxes on disbursements, but you also do not get to deduct the contributions.
  • 401(k) contributions happen before income taxes, so you will have to pay at the time you withdraw.

What the Difference Is Between a 401(k) and an IRA Regarding Withdrawals and Penalties

When can you take out money from your retirement account? These investment schemes are tightly regulated, therefore it is important to be informed.

Early Withdrawal Penalties

Most withdrawals from IRAs that occur before you reach age 59½ are classified as early withdrawals. In other words, you pay an income tax penalty of 10 percent of the withdrawal amount. Roth IRAs, however, make some exceptions, such as being able to withdraw:

  • The precise amount of your contributions without paying penalties if you are under the age of 59½.
  • As much as you want if you are older than 59½ and your Roth IRA is at least five years old.
  • Exempt amounts for things like allowed college costs and purchasing your first home.

401(k) early withdrawal penalties are also pegged at 10 percent. These plans, however, may make allowances for certain loans that must be repaid to the account. Some also allow hardship withdrawals that you do not have to pay back. For instance, you might qualify for a hardship distribution if you get fired and suddenly incur a huge medical expense.

The 401(k) contracts written by employers and their legal teams can also make life a bit more complicated. These plans restrict you by defining triggering events that must occur before you or your beneficiaries can withdraw without incurring a penalty. Typical examples may include your death, coming of retirement age, termination or disability.

IRAs, 401k, required distributions

The Difference Between IRA and 401(k) Required Distributions

Traditional IRAs

Mandatory IRA distributions, which take the form of required minimum distributions, or RMDs, only apply to traditional, SEP and SIMPLE IRAs. They go into effect when you reach age 70½, and their amount depends on factors like your age, account balance and the age of your spousal beneficiary. Roth IRAs do not have RMDs while you are alive, but if your spouse inherits your account, he or she will be subject to different rules.

401(k)s

These plans fall under the same RMD rules as traditional IRAs. Triggering events may also force your hand.

Rollovers

A rollover entails withdrawing money from an IRA or 401(k) and putting it into another eligible retirement investment. In other words, rollovers can help you:

  • Avoid early withdrawal penalties.
  • Maintain your money’s tax-deferred growth.
  • Lower your administrative costs.
  • Simplify your finances by combining retirement accounts without losing money to penalties.

Rollover IRAs

You can roll over money from one IRA to another without incurring a tax penalty as long as you complete the move within 60 days. There is no limitation on how much of the account you can transfer either.

You are only allowed to roll over an IRA once per year. There are exceptions, however, by:

  • Having your IRA’s trustee handle the transfer in a direct rollover.
  • Rolling over a traditional IRA into a Roth account in a conversion.

You are prohibited from rolling over certain withdrawals, such as loans, hardship distributions and RMDs. Before initiating the process, it is wise to ensure that your target retirement plan accepts rollovers.

Backdoor Roth

Roth conversion rollovers are also known as backdoor Roths. They are commonly used by high earners who want to sidestep the upper-income limits of Roth eligibility since these restrictions do not apply to Roth conversions. You will still have to pay taxes on any untaxed funds in the original account, but you can get around the contribution limits.

401(k) Rollover

Rolling over a 401(k) lets you be more selective about your investments. Completing this process can also make it easier to organize your portfolio if you have worked for multiple employers who contributed to retirement accounts.

As with IRAs, you can perform an indirect rollover where you receive the money and then put it into a new qualified account. You should have opened this savings plan already since the 60-day penalty rule still applies. If that is too complicated, you can ask your employer’s 401(k) manager to complete the rollover directly.

You will also need to know whether your 401(k) is a traditional 401(k) or a Roth 401(k). If you switched from a traditional 401(k) to a Roth-style IRA, you might incur conversion taxes. You are not permitted to go from a Roth to a traditional account.

Putting Your Retirement Savings Plan Into Action

No matter whether you favor IRAs, 401(k)s or a blend of both, saving for retirement is easier when you have options. That is why the M1 Finance platform makes it simple to familiarize yourself with your portfolio. From industry-leading education to fee-free accessibility, you retain control of how your investment strategy takes shape.

M1 Finance is powered by an intelligent, secure software that eliminates the go-betweens. By signing up, you have access to tools that can help make smarter borrowing choices in order craft a customized portfolio that will invest in your future. Our premium tools help keep you informed so that you can minimize your tax burden and manage your assets from anywhere.

Discover why some of  the nation’s leading investment gurus think that M1 Finance is the best of both worlds. Cultivate better portfolio habits and see your retirement nest egg grow by signing up today.