IRA vs 401K

Asset Management Tutorial

Difference Between IRA vs 401k

There is a common myth that a salaried person holds in his mind that they have to choose between IRA and 401k. However, the truth is that a person can invest in both IRA vs 401k categories of tax avoidance instruments which protects one’s retirement savings. Yes, that is the truth.

Both IRA vs 401k are few of the most common variants of a defined contribution plan which offer a tax benefit for retirement savings. If a person is planning the retirement savings wisely, he/she is probably investing in both well-funded IRA and 401k. However, there are certain basic distinctions between the IRA (traditional IRA is covered) and 401(k) which will be brought to light in this article.

What is IRA?

An IRA is an individual retirement account for people under the age of 70.5 years who are not offered the benefits of 401(k) by their employers. However, people enjoying the benefits of 401(k) can also invest in IRA. The amount contributed to IRA account is basically pre-tax income which means that the amount enjoys tax deduction and will be taxed only when withdrawn at the time of retirement. During 2019, employees below the age of 50 years are allowed to contribute up to $6,000 of pre-tax income to IRA, while those over the age of 50 years can contribute an additional catch-up contribution of $1,000.

What is 401k?

A 401(k) is an authorized employer-sponsored defined contribution retirement plan, unlike IRA. The amount that is being contributed to 401(k) account is also pre-tax income which means that the amount will not be taxed during the year in which the person earned it. However, the amount will be taxed when it will be withdrawn after the retirement. During 2019, employees below the age of 50 years are allowed to contribute up to $19,000 of pre-tax income to a 401(k), while those over the age of 50 years can contribute an additional catch-up contribution of $6,000.

IRA vs 401k Infographics

Here we provide you with the top 6 difference between IRA vs 401k

IRA vs 401k – Key Difference

The key differences between IRA vs 401k are as follows –

During 2019, the contribution limit in case of IRA stood at $6,000 every year for people below the age of 50 years, while that for 401(k) stood at $19,000. Meanwhile, the additional catch-up contribution for people above the age of 50 years stood at $1,000 for IRA and $6,000 for 401(k) during 2019.
In the case of early withdrawals, distributions from traditional IRAs are subject to 10% penalty for a person below the age of 59.5 years while there is no penalty for a person above 59.5 years of age. Distribution due to early withdrawals from 401(k) is subject to an onerous tax of 20% unless there is a “distributable event’ such as an employee leaving the employer or retiring.
While companies don’t offer any matching contribution for IRA’s, most of the employers offer a matching contribution up to a certain percentage of the salary in the case of 401(k).
An IRA plan costs relatively less due to a lower amount of money managed and no annual fees, while on the back of higher amount of money to manage a 401(k) plan charges higher fees.
An IRA plan offers diverse investments options which include stocks, funds and fixed income investments since IRAs are self-directed. On the other hand, a 401(k) have limited investment options.

IRA vs 401k Head to Head Difference

Let’s now look at the head to head difference between IRA vs 401k

Basis	IRA	401(k)
Contribution	One can contribute $6,000 to an IRA every year ($7,000 for people above 50 years) in 2019	One can contribute $19,000 to a 401(k) account every year ($25,000 for people above 50 years) in 2019
Early Distributions	Early distributions from traditional IRAs are subject to 10% penalty for a person below the age of 59.5 years (no penalty for a person above 59.5 years)	Early distributions from a 401(k) are subject to onerous 20% tax unless the employee leaves the employer or retires
Federal taxes	Federal and state taxes are applicable to distributions from traditional IRAs after the age of 59.5 years	Distribution from a 401(k) is subject to mandatory federal tax at the time of withdrawal
Employer contribution	Companies don’t offer any matching contribution for IRA’s	Most of the employers offer a matching contribution up to a certain percentage of the salary
Cost of investment	An IRA plan costs relatively less compared to a 401(k) plan since there is a usually lesser volume of money to manage and also IRAs don’t charge any annual fees	Fees are higher for 401(k) plans due to a higher volume of money managed in a 401(k) account
Investment options	One can make any kind of investments which include stocks, funds and fixed income investments since IRAs are self-directed	Most of the 401(k) plans have limited investment options such that an average 401(k) plan offers around 20 funds

Conclusion

As can be seen from the above explanations that both IRA vs 401k are the categories of tax planning are somewhat different in nature and serve important roles in the retirement savings. IRA vs 401k offer tax-deferred payout from interest income, dividend, and capital gains. However, one needs to assess his/her own requirement in terms of cost and benefits to arrive at a balanced retirement plan. As such it is crucial to understand the differences between the two to apply them successfully in retirement savings planning. I hope the article helps you to decipher the two tax shelter planning for a healthy retirement.