If someone asked you to explain the difference between an Individual Retirement Account (commonly referred to as an “IRA”) and a 401(k), could you do it? If not, here’s a look at these two popular retirement savings accounts, and their differences.
What is an IRA?
An IRA is an account set up through a financial institution that allows you to save for retirement on either a tax-deferred basis (with a Traditional IRA), or with tax-free growth on pre-taxed contributions (with a Roth IRA).
With a Traditional IRA, the money you put into the account is not taxed until you begin withdrawing it during retirement. When money is withdrawn from a Traditional IRA in retirement, that money is taxed according to your income tax rate. And usually, people are in a lower tax bracket in their retirement years than they are during their employment years, when they’re making contributions.
Also, Traditional IRA contributions are generally tax deductible. The exact amount of your contributions that are tax deductible will depend on a variety of factors such as your marital status, income level, and whether you are participating in other types of retirement plans.
The IRS sets contribution limits for Traditional IRAs. How much you can contribute annually depends on your age. For 2019, those under age 50 can contribute up to $6,000 per year. For those older than 50, the contribution limit is $7,000 to allow for "catch-up" contributions.
A Roth IRA differs from a Traditional IRA in that your contributions come from “after-tax” dollars. The plus side of funding your IRA with money that you’ve already paid taxes on, is that the money grows within the account tax-free. In other words, you won’t pay taxes on your earnings, and you won’t pay taxes when you withdraw the money in retirement. And keep in mind that the IRS sets income limits for Roth IRAs, which impact the amount you can contribute annually.
Generally speaking, you can begin withdrawing from a Traditional or Roth IRA after the age of 59 ½. It’s important to note that withdrawals made before the age of 59 ½ are subject to a 10% early withdrawal penalty. There are some exceptions to the early withdrawal penalty though. The penalty can be waived for certain withdrawals, such as those for qualified higher education expenses, buying a first home (up to $10,000), or being reimbursed for qualified medical expenses.
What is a 401(k)?
The main difference between a 401(k) and an IRA, is that a 401(k) is generally only available through your employer (there are however special 401(k) accounts for individuals who are self-employed). Under a 401(k), your employer typically matches the contributions you make (either in full, or in part), up to a certain amount. It’s kind of like receiving “free money” from your boss!
Another difference between a 401(k) and an IRA is that you can contribute more to a 401(k) than you can to an IRA each year. The IRS sets the limit for how much employees can contribute to their 401(k) accounts. For 2019, the limit for employee contributions is $19,000. The amount you and your employer both contribute cannot exceed $56,000 in 2019.
While 401(k) accounts are also subject to a 10% tax on withdrawals made before age 59 ½, some employers will allow you to take a loan from your 401(k). This option is not available with an IRA. The terms of these loans will vary by employer, and it’s also important to note that if you leave your employer before you finish paying back the loan, you could be required to pay the loan back, in full, within a very short amount of time.
Ultimately, whether you choose to save through a 401(k), an IRA, or both, the important thing is that you’re saving for retirement. And remember that it’s always a good idea to consult with a tax professional or financial planner before making any major investment decisions. With your retirement goals in mind, they should be able to help you formulate the best plan for your unique financial situation.