401k plans and Roth IRAs are two popular retirement savings plans that give tax benefits. However, since they are still different with respect to the contribution limitations, you can invest in both plans to get the most out of it. Therefore, first, let us individually understand what these plans are. The differences between the two need to be still considered before deciding how much to invest in which plan. Hence, we will discuss the major difference between IRA and 401k to help you choose the best one.
A 401k plan is an employer-sponsored income plan which works on a tax-deferred basis. It is named after section 401k of the Internal Revenue Code. A part of the employee’s salary is contributed towards the plan for which tax is not deducted. The contributions made into a 401k account are then invested in various funds like stocks, mutual bonds, etc. as per the various options provided by the plan provider, all within the same account. The earnings are not taxed and are allowed to grow within the plan until withdrawal. The investor can withdraw this amount only after his retirement which will be taxed at the time of withdrawal. Till date, there is an annual investment cap of $18,000 for investors below the age of 50 and up to $24,000 for those above 50 years old. There are certain employers who also contribute towards this individual employee’s 401k accounts to match the employee’s contribution, thereby letting him gain an additional tax-deferred income.
A Roth IRA, however, is a plan individually set-up by the employee with a financial institution without the involvement of the employer. Here, the contributions are made for which the taxes are applied and then invested in a Roth IRA account. This money is later used for various market investments like mutual funds, stocks, etc. The amount thus is allowed to grow until withdrawal. Since the taxes are already deducted at the time of contributions, there will be no others taxes charged later during withdrawals. Also, since there is no employer involved in this plan, there will be no additional contributions made by the individual’s employer and the account will be entirely controlled by the account owner. The investment choices will not be limited to what is provided by the financial institution and thereby gives a greater degree of freedom for the employees. Till date, there is an annual investment cap of $5,500 for those under the age of 50, and an additional provision of $1,000 for people who are 50 years or above.
Let’s look at the main difference between IRA and 401k plans are in the areas of tax treatment, investment options, and possible employer contributions. Let us discuss these a little more in detail.
Involvement of the employer in setting up of an account: Since a 401k is an employer-sponsored program, you will be eligible to invest in it only if your employer provides this plan or choose to set up one for yourself if you’re self-employed. However, in the case of an IRA account, any individual who meets the criteria of age, employment, etc. can easily make an investment.
The employer’s role in making contributions: An employer may make a portion of the employee’s contribution into a 401k account thereby giving free money without taxes to the investor/employee. However, since an IRA is set up individually, there will be no equivalent contributions by the employer.
Maximum investment limits in the plans: A 401k provides a cap of $18,000 per year for those below the age of 50 and has a catch-up provision of an additional a $6,000 for those between 50 to 65 years of age. The employer’s contribution is not considered in this limit. Moreover, a Roth IRA lets you contribute up to $5,500 per year if you’re under 50 and up to $6,500 if you are 50 or above years old. Hence, the contribution limit of a 401k is higher than an equivalent IRA contribution limit.
The amount saved on paying taxes based on the taxation brackets: I may make more sense to invest in a Roth account if you believe that you will be in a higher income tax bracket when you retire than you are currently in today. You will be paying a known percentage of tax on your contributions rather than having to worry about paying an unknown larger percentage of taxes at the time of withdrawals as in a 401k plan.
Flexibility in making investments within a savings account: An IRA allows more control over individual accounts than a 401k. You can choose from a larger pool of investment options for your IRA accounts like individual stocks, bonds, real estate, etc. However, the options are limited to the 401k holders as the funds are partially controlled by their employers which often includes pre-packed products like the target date funds with consideration of expense ratios and underlying costs.
Time limit of the distributions: In case of comparing the Roth versions of both plans, the Roth IRA provides the benefit of a longer or forever existence of the account without any minimum required distributions. This can also be passed down to the next generation thereby providing them with tax-free earnings. However, a Roth 401k will require distributions starting at age of 70½. However, if you prefer to continue keeping the savings tax-free, you will have to convert the account from a 401k to a Roth IRA.
These are some points which state the main difference between IRA and 401k.
