The 401(k) and the IRA are two of the most popular investment and retirement savings vehicles available. Although they share similar qualities, but 401(k)s and IRAs are actually two distinct products, each with specific advantages designed to help you succeed in your savings and investment plan.
Difference #1: Eligibility
Most people of working age can open an IRA — after all, its very name stands for “Individual Retirement Account.”
However, a 401(k) is an employer-provided defined-contribution plan, named after the subsection of the Internal Revenue Code in which it is described. Only people who are employed by companies that participate in 401(k) plans are eligible to make 401(k) investments.
Difference #2: The Employer Match
Since an IRA is all about the individual, you’ll be the only person making contributions to your IRA account.
However, a 401(k) is an employer-provided plan. This means that many employers choose to incentivize employees to make 401(k) contributions by offering an employer match. Employers elect to match a pre-defined percentage of each employee’s individual 401(k) contribution; that is, if you elect to contribute $100 of your monthly salary to your 401(k) plan, an employer offering a 100% match will also contribute a monthly $100 to your plan.
The employer match is one of the few sources of “free money” we’ve got, so take advantage of it.
Difference #3: Contribution Levels
For the 2014 tax year, you can contribute up to $5,500 to your IRA if you are under age 50, and up to $6,500 if you are age 50 or older. (If your taxable compensation is under $5,500/$6,500 you can only contribute up to the value of your taxable compensation.)
This IRA contribution limit applies both to traditional IRAs and Roth IRAs simultaneously — you can’t open a traditional IRA and deposit $5,500 and then open a Roth IRA and deposit a second $5,500.
401(k) plans, on the other hand, allow you to contribute up to $17,500.
This is where managing an IRA and a 401(k) plan becomes a good option: in flush years, you can max out both vehicles, and in leaner years, you can continue to fund the 401(k) and earn your “free money” employer match while letting the IRA hold steady until you can afford to begin funding it again.
Likewise, if you find yourself between employers or switching to a job or freelance career where no 401(k) plan is offered, you can continue to fund your IRA and let your 401(k) continue to earn interest on your previous contributions.
Difference #4: Taxes
For those on moderate to low incomes, traditional IRAs are typically tax deductible if neither you nor your spouse are covered by a work retirement plan such as a 401(k). If you or your spouse have both a work retirement plan and a traditional IRA, your IRA contribution is still tax-deductible but your deduction may be limited depending on your total earnings. Your withdrawals and distributions are taxed.
When you contribute to a Roth IRA, your contribution is not tax-deductible. On the other hand, qualified distributions are not taxed, as long as you wait until you are age 59 ½ to begin taking your distributions or fall under another qualified distribution scenario.
401(k) plans can take either pre-tax or post-tax paycheck contributions, and the earnings are tax-deferred until you begin making withdrawals.
Difference #5: Allocating Your Investment Funds
Choosing how to allocate your investment funds is one of the most important parts of both the 401(k) and the IRA. Different funds have different levels of risk, and different funds also have different expense ratios, which represent the percentage of fees you pay towards fund management.
With an IRA, you can choose pre-packaged funds, such as the popular lifecycle funds, or in many cases you can do every step of your fund allocation yourself.
With a 401(k), well — as Future Advisor has noted previously, your expense ratio rates are often determined by your HR department, and your 401(k) plan allocation interface may guide you towards one of a handful of pre-set portfolios based on your risk tolerance. However, it is often possible to go into your 401(k) plan and re-balance your portfolio if you don’t like any of the preset options.
The views expressed represent the opinion of the author and are not intended to reflect those of FutureAdvisor or serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities.