Differences Between IRA and 401k

IRA or individual retirement accounts is an individually owned account and the same is doesn’t needs to be established by an employer and a participants can easily set up his/her IRAs with an individual retirement account provider whereas an employee can set up 401k plan only with an employer that is eligible for 401k retirement plan options.

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 categories of tax avoidance instruments which protects one’s retirement savings. Yes, that is the truth.

Both 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 of IRA (traditional IRA is covered) vs 401k which will be brought to light in this article.

What is the IRA?

An IRA is an individual retirement account for people under the age of 70.5 years who are not offered the benefits of 401k by their employers. However, people enjoying the benefits of 401k can also invest in IRA. The amount contributed to the IRA account is basically pre-tax income which means that the amount enjoys tax deduction and will be taxed only when withdrawn at the time of retirement.

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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 401k plan is an authorized employer-sponsored defined contribution retirement plan, unlike IRA. The amount that is being contributed to the 401k 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 However, the amount will be taxed when it will be withdrawn after retirement.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

Let’s see the top differences between IRA vs 401k.

Key Difference

During 2019, the contribution limit in the case of IRA stood at $6,000 every year for people below the age of 50 years, while that for 401k 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 401k during 2019.
In the case of early withdrawals, distributions from traditional IRAs are subject to a 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 401k 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 401k.
An IRA plan costs relatively less due to a lower amount of money managed and no annual fees, while on the back of the higher amount of money to manage a 401k plan charges higher fees.
An IRA plan offers diverse investment options which include stocks, funds and fixed income investments since IRAs are self-directed. On the other hand, a 401k have limited investment options.

IRA vs 401K Comparative Table

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	It cost 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 the categories of tax planning that are somewhat different in nature and serve important roles in the retirement savings. Both 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.

IRA vs 401k