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IRA vs 401k: What Are the Key Differences?

IRA vs 401k: is there a difference?

Yes, there is a big difference between an IRA and 401k. The main difference between the two is that an IRA (Individual Retirement Account) is a form of retirement plan that you can create and fund yourself.

Whereas, a 401k plan is a tax advantaged retirement plan created by your employer, in which you can contribute a certain amount from your salary.

Let’s explore more key differences between IRAs and 401(k)s.

Note, if you have questions beyond an IRA and 401k plans, a financial advisor can help you determine the best saving options to help you reach your retirement income goals.

IRA vs 401k: Understanding the difference between the two.

There are several tax advantaged retirement plans out there. They are IRA, Simplified Employee Pension aka SEP, a Keogh Plan, or a 401k plan.

Each of these plans that can help you save for retirement. And the money you invest in them grows free of taxes. However, they have their own unique benefits.

So, knowing which ones fit your individual needs can be difficult. Therefore, it’s always a good idea to compare several plans to make the right choice. 

But for purpose of this article, I will only focus on IRA vs 401k.

What is a 401k?

A 401k plan is a retirement savings plan that is offered by your for-profit company. If you work for a non-profit company, then you may have access to what’s called a 403(b) plan.

Your contribution to a 401k plan is deductible on both federal and state taxes in the year you make them. A 401k plan allows you to contribute up to $19,500 per year (for tax year 2020).

If you’re an older employee, at least age 50, you can contribute an additional $6,500 (called a catch-up contribution limit), making it a total of $26,000 each year.

Read: 401k Contribution Limits for 2020: What Are They?

In most cases, your employer may offer a match. That is if you contribute 3% of your paycheck, your employer may match it with 3%, making your 401k contribution 6%.

Under some circumstances, you may be able to withdraw money from your 401k before age 59 1/2, but only if you show financial hardship.

Otherwise, you’ll get hit with a 10% penalty and federal, state and local taxes on that amount. See more on the IRA vs 401k withdrawal rules below.

2020 401k Maximum Contribution
Under age 50$19,500
Age 50 plus$19, 500 + $6,500 = $26,000

What is an IRA?

Anyone who is earning an employment income (or receiving alimony) can open an IRA account.

An IRA is also a retirement account that grows tax free until you withdraw the money.

It is an individual account and not tied to your employer.

Unlike a 401k, your yearly contribution to an IRA is much less. You may contribute $6,000 into your IRA for the year of 2020. If you are 50 years old and older, you may contribute up to $7,000.

Both wife and husband can contribute up to $6,000 each year, making it a total of $12,000 even if only one spouse is working. Your can deduct all of your traditional IRA contributions every year.

However, your IRA may not be deductible if you or your spouse participates in a retirement plan at work, like a 401k.

If you cannot deduct your IRA contribution, consider opening a nondeductible account called a Roth IRA.

If you’re single with an adjusted gross income (AGI) of less than $124,000 or married filing jointly with an AGI of $196,000, you can contribute up to $6,000 per year to a Roth IRA.

Those who are 50 years old and older can contribute $6,000.

2020 IRA Maximum Contribution
Under age 50$6,000
Age 50 plus$7,000

What’s the difference between an IRA plan and a 401k plan?

IRA vs 401k

  • An IRA is a retirement account that you create, while a 401k is a retirement account that your employer sets up for you, and one that you fund. In some cases, your employer will match a portion of your 401k contributions.
  • Maximum contribution: A 401k allows you to contribute $19,500 and up to $26,000 if you’re an older employee–at least 50 years of age. Whereas, with an IRA you can contribute up to $6,000 each year. Your spouse, regardless whether he or she is working, can also contribute up to $6,000 into your IRA, making it a total of $12,000 per year. If you are 50 and older, you can put up to $7,000 in your IRA each year. 
  • Tax-deduction: Your contributions to a 401k are tax deductible in the year that you make them. Whereas, your contributions to an IRA may or may not be tax deductible.
  • You decide where to open your IRA account (i.e., at a bank, mutual fund company or brokerage firm), while with a 401k must be established by your employer.

IRA vs 401k Withdrawals Rules

With both 401k plans and IRA plans, you can withdraw money before retirement. But the penalties for doing so are outrageous.

With an IRA, any money withdrawn before the age of 59 1/2 is subject to a 10% penalty, plus federal, state and local taxes on that amount. However, there are exceptions.

The 10% penalty won’t apply if you use the money to pay for medical expenses, to buy a house for the first time, and to pay for higher education for yourself, spouse, child, or grandchild.

The same withdrawal rules apply for 401k accounts. Like an IRA,you’ll get hit with a 10% penalty if you make withdrawals from your 401k before age 59 1/2. Like an IRA, there are some exceptions to withdraw money from a 401k without a penalty.

The exceptions are that if you experience financial hardship, such as:

  • Paying for medical expenses
  • Paying for a funeral or a primary residence.
  • You become totally disabled.
  • You are recently divorced and you have a court order to give money to your ex-spouse or child.

However, showing financial hardship can be hard to prove. You really have to show that you can’t get the money from a bank or from any other sources.

The rules regarding withdrawals from your 401k and IRA can be complex. So, always consult with a tax or financial advisor for more information.

The advantages and disadvantages of a 401k plan versus an IRA plan.

The great advantage a 401k plan has over an IRA is the high maximum contribution you can make. A 401k plan allows an employee to contribute $19,500 a year and $26,000 if you are older than 50.

With an IRA, as you know, the current maximum is $6,000 a year of $7,000 if you are over 50 years old.

If your employers offers a 401k plan at work, make sure you take advantage of it. Another advantage of 401k plan over an IRA is that your employer can contribute matching a dollar for each dollar the employee contribute.

That’s a big plus!

However, with an IRA, and unlike a 401k, you have more control on where you want to set up your retirement account (i.e, banks, brokerage firms, mutual funds, etc).

You’re also responsible for creating your own portfolio and monitoring your account. 

Read: How Much Is Enough for Retirement?

IRA vs 401k: which one should I choose?

Is it better to have a 401k or IRA? An IRA is a good option if your employer does not offer a retirement savings plan, or if you have already maxed out your employer’s 401k plan.

However, if you’re choosing between an IRA and a 401k, a 401k plan is a better choice.

That is because the ceiling on how much you can contribute each year on a 401k plan is much higher than an IRA plan.

Therefore, your money has the potential to grow much faster. (Wondering how to grow your 401k account? Here’s how to save $1 Million in your 401k account.)

But if you want to contribute to both an IRA and 401k, start with the 401k plan first, max it out. Then, move on to an IRA. 

IRA vs 401k: the bottom line

Both an IRA and 401k plans are two of the best vehicles to save for retirement. That is because the money grows free of federal and state taxes.

IRAs are similar to 401k accounts, but there are key differences.

One main difference between an IRA and 401k is the contribution limit. If you qualify for both and have additional questions, consult with your accountant or financial advisor to determine which is type is the best for you.

More on retirement:

Speak with the Right Financial Advisor For You

If you have more questions beyond the difference between IRAs and 401ks, know that you can talk to a financial advisor who can review your finances and help you reach your goals (whether it is making more money, paying off debt, investing, buying a house, planning for retirement, saving, etc).

Find one who meets your needs with SmartAsset’s free financial advisor matching service. You answer a few questions and they match you with up to three financial advisors in your area. So, if you want help developing a plan to reach your financial goals, get started now.

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