What's the difference between a 401(k) and an IRA?

When planning for your retirement, you have a choice of two popular types of retirement accounts i.e. a 401(k) and an IRA. A 401(k) is an employer-sponsored account while an Individual Retirement Account (IRA) is available to anyone who meets the income requirement.

While a 401(k) and an IRA serve the same purpose, they have certain differences that make them desirable or unattractive to participants. A 401(k) and an IRA differ on the basis of eligibility requirements, contribution limits, investment options, beneficiaries, and distribution tax rules.

A 401(k) is an employer-sponsored retirement account, and a proportion of your monthly paycheck goes towards your retirement savings. In some cases, an employer may match a percentage of your monthly contributions, which equates to free money. On the other hand, you can open and maintain an IRA on your own, and enjoy the various incentives and tax benefits it offers.

What is a 401(k)?

A 401(k) is a tax-deferred retirement saving account, and you are not taxed when you contribute towards your retirement. Instead, you pay taxes on 401(k) money when you make an early withdrawal or in retirement. Most companies offer 401(k)s as a benefit to help their employees save for retirement through elective salary deferrals. Usually, a percentage of your monthly paycheck is automatically withheld before the money gets to you and sent to the 401(k) plan.

When you enroll in a 401(k), you are given the choice of investing the retirement money in a mutual fund or exchange-traded funds. These investment options are selected by the plan sponsor, and they are designed to meet the financial goals and risk tolerance of the employee. An employee can decide to take on a conservative or aggressive risk approach to their investment.

Some employers offer a contribution match as a way of encouraging participation in 401(k). In this case, the employer matches the employee’s contributions to the 401(k) up to a certain percentage or for every whole dollar contributed. For example, if the employer offers a 3% match and your annual salary is $70,000, it means that the employer will match your contribution up to $2,100 yearly.

What is an IRA?

An IRA is a tax-deferred retirement savings account that is opened and maintained by an individual, and it can be held by a brokerage, bank, or investment firm. Unlike a 401(k) where participation is restricted to people employed by companies that offer 401(k) plans, anyone can open an IRA account. One of the main selling points for IRAs is that participants have more investment options than a 401(k), and you can choose between stocks, certificates of deposits, real estate, index funds, exchange-traded funds, etc.

The following are the various types of IRAs:

•  Traditional IRA: As a tax-deferred account, contributions to a traditional IRA and any returns earned are not taxed. You only pay income taxes if you withdraw the retirement money.
• Roth IRA: Contributions made to a Roth IRA are taxed on deposit. Qualified distributions in retirement will be tax-free.
• Rollover IRA: When you change jobs, you can rollover a 401(k) to an IRA. This option gives you greater control over your investments since you can no longer contribute to the former employer's 401(k) plan.
• SEP IRA: A SEP IRA is an IRA offered by employers to their employees, and it shares some similarities with a 401(k). However, a SEP IRA only allows contributions from the employer.
• SIMPLE IRA: This IRA allows employers to match up to 3% of the employee’s annual contribution, or set up a non-elective 2% contribution of the employee’s salary.

Key Differences Between a 401(k) and IRA

Knowing how a 401(k) and an IRA differ can help you pick the best retirement account that meets your savings goals. Here are the main ways that a 401(k) and an IRA differ:

Eligibility

To participate in the employer’s 401(k) plan, you must be working for an employer that offers a 401(k) retirement plan. The employer may set a certain age or years of service requirement that employees must meet to participate in the 401(k) plan.

An IRA does not have restrictions on who can join. Since it is not employer-sponsored, any individual with an income can join and start saving for their future financial security. Some institutions may have a minimum contribution limit requirement.

Contribution Limits

A 401(k) and an IRA have different requirements on the minimum amount you can contribute each year. Generally, a 401(k) has higher contribution limits than an IRA, and you can contribute up to $19,500 to a 401(k) in 2021. The IRS allows plan participants to make additional catch-up contributions of up to $6,500 for those aged 50 and older.

With an IRA, the contribution limit for 2021 is up to $6,000. The IRS allows a catch-up contribution of up to $1000 for those 50 years and older.

Investment options

A 401(k) plan limits participants to the investment options that the employer or plan administrator chooses. Mostly, a 401(k) plan offers mutual funds and exchange-traded funds. Participants can choose to invest in one type of investment, or spread out the retirement money across several types of investments with different risk levels. If you want to invest in a publicly-traded stock that is not listed in the list of investment options, you may be forced to open an alternative retirement account like an IRA.

In contrast, an IRA gives participants the freedom to choose their preferred investments, and they are not limited to a specific list of preselected investments that the employer chooses. You can use your retirement savings to invest in different investments such as stocks of publicly-traded companies, REITs, index funds, bonds, certificates of deposits, etc.

Beneficiaries

With a 401(k), your spouse automatically becomes your beneficiary and stands to benefit from the accumulated retirement savings when you die. If you wish to change the beneficiary, your spouse must consent to the change in writing. If you are single, you will be required to name a beneficiary.

On the other hand, an IRA allows participants to name whoever they prefer to be the beneficiary. The beneficiary can be a spouse or someone else, and they can change the beneficiary without requiring spousal consent.

Distributions and Taxes

A 401(k) and an IRA are both tax-deferred retirement savings accounts, and the contributions are tax-deductible in the year when they are made. The retirement money is only taxed when you make a withdrawal.  

However, if you elect to open a Roth 401(k) or Roth IRA, these accounts are funded with pre-tax dollars, meaning that they are taxed when the contributions are made. Withdrawals made in retirement are tax-free. A Roth 401(k) or Roth IRA is a good option if you project that future distributions will push you to a higher tax bracket; hence, you are better off paying taxes now than worrying about taxes in retirement.

You can start taking a distribution from both retirement accounts when you are 59 ½. If you are 72, you must start taking mandatory distributions and paying taxes on the withdrawal amount. Early withdrawals before 59 ½ are charged a 10% penalty tax, in addition to the income taxes due.

Choosing Between a 401(k) and IRA: What Should You Pick?

Both 401(k)s and IRAs have their benefits and drawbacks, and you should pick the option that helps you achieve your savings goals.

If your employer has a 401(k) plan, you should consider enrolling in the plan and start saving for your retirement early if you are eligible. A 401(k) has higher contribution limits and it can help you accumulate your savings over time. However, the limited investment options mean that you cannot invest in a desired investment that is not among the available investment options. If your employer offers a match, you should consider taking up the offer and watch your investments grow over time.

If you are looking to get greater control over your retirement money, you should consider rolling over your old 401(k)s to an IRA. An IRA allows investors to directly manage their portfolio, and hold the funds in an IRA savings account. If you want to buy your first home, pay medical bills, pay higher-education expenses, you may also qualify to take an early withdrawal without paying the 10% penalty tax. However, you will still be required to pay income taxes on the withdrawal amount.