IRA vs. 401(k): What is the difference?
Individual Retirement Accounts, also known as IRA’s and 401(k) plans, are two of the most common vehicles used to save for retirement. Both offer tax benefits and have flexible contribution options. Both can provide retirement savings benefits to employees as well as business owners. You can contribute to both simultaneously; the main difference is that employers offer 401(k) ‘s, but individuals can open IRA’s. IRAs typically offer more investments, but 401(k) allows higher annual contributions.
But that is all convoluted. What is the difference, and which one is better?
Many companies offer 401(k) plans as a benefit to help workers prepare for their retirement years. You can use 401(k) to save a portion of your pretax income in an account set up by your employer. The amount you contribute is automatically deducted from your paycheck before it reaches you, similarly to taxes.
Some employers will match up contributions to a certain amount to encourage participation in these plans, usually a 3% match. Win-win all round!
Another thing to know about 401(k) plans is that they tend to reward company loyalty through a process known as “vesting.” To completely own all contributions to your 401(k), including your employer match, you must become fully vested or risk losing a portion of it if you leave your job.
An IRA is another way to save and invest for your retirement, but this is something you can do yourself rather than through an employer. You can open up an IRA yourself at a bank, credit union, investment firm, broker, or through a mutual fund provider. You can choose to contribute a portion of your earned income periodically to the IRA. There are several types of IRA – traditional, Roth, SEP, and SIMPLE. Each has different rules regarding eligibility, taxation, and withdrawals. The main withdrawal rule is that there is a penalty if you withdraw money before the age 59 1//2.
IRA also offers a wide selection of investment vehicles, allowing your money to go further.
A 401(k) may provide an employer match, but an IRA does not. However, an IRA generally has more investment choices than a 401(k). Anyone with an eligible earned income can open an IRA, but a 401(k) is only available through an employer and has a higher contribution limit. An IRA allows you to avoid the 10% early withdrawal penalty for certain expenses like higher education, first home purchase of health insurance if you are unemployed. Furthermore, you don’t have to be fully vested, unlike with the 401(k).
Furthermore, you may have little control over your money with 401(K). Instead, an employer may have an assigned account advisor to manage fund movements and investment choices.
But if we get down to the nitty and gritty of it, the whole 401k vs IRA debate may be a bit intimidating, so it is best to remember the basics. Take advantage of your employer’s plan if one is available, save as much as makes sense for your budget and future needs, and select your investments wisely.