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Understanding the difference between 401k and IRA

An IRA and a 401k are similar in many ways. However, there are many a difference between a 401k and an IRA too, the biggest difference being how much you can contribute.

Individual Revenue Account – IRA
An IRA is where you can contribute up to $5500 per year and on the basis of your income, you may be able to deduct your contributions to an IRA, lowering your current tax bill. There is a limit to the contribution and the deduction. Another benefit is your investment is safe from taxes until you start taking the money out. This is a retirement fund and needs to be safe until the age of 59 and half years or you face a ten percent penalty. Any withdrawal before the said age is taxed. With proper planning, you will pay less tax than what you were paying while you were working.

401k is the common employer-sponsored retirement fund. There can be a combined contribution from the employee, employer, and any other profit sharing of just $54,000 per year. This comes up to $60,000 per year if you have reached 50 years (2017 numbers). There is often a schedule for employer contribution that is if you leave your job during a certain period you forfeit some contributions. Keep that in mind while giving notice and don’t quit before another deadline. 401k is a limited investment option your plan may not have a great array of choices.

A traditional IRA and 401k have similar terms on how they get treated for taxes. The main difference between 401k and IRA boils down to the contribution limits, access to funds, and eligibility. The others are listed below:

  • A 401k plan is an employer-sponsored so you have to work for the company in order to become a member of the 401k. In almost all cases, anyone under 70 years the age of 70.5 who earns income can participate in an IRA.
  • The 401k plan usually has better creditor protection than an IRA since it is an employer-sponsored investment plan.
  • 401k plan contributions are usually made through payroll deductions. IRA contributions usually are done by the individual writing the check and depositing in the IRA.
  • A 401k offers loan privileges. An IRA does not have loan privileges.
  • A 401k can have an employer match the provision. IRA does not.
  • For 401k, the contributions are of higher amounts of $18K for 2017. An IRA only has contribution amount of $5,500.
  • The catch-up amount for 401k is $6,000 in 2017. The IRA catch up is $1,000 in 2017.
  • Investment options for 401k are more limited than in IRA.
  • Both IRA and 401k are retirement accounts and IRS provides special tax benefits to the money contributed towards and held in these accounts. These invested funds grow tax-deferred and the investors receive an income tax deduction for the year they contribute. Tax deduction for contributions to IRA depends on your tax situation.
  • For 401k, you can contribute more each year than IRA or you can contribute to both in any year. Furthermore, if you are over the age of 50, you can add more “catch up contributions.”

    2016/2017 annual personal contribution limits [by IRS]:

  • Normal contribution for IRA – $5,500; 401k – $18,000
  • 50+ catch up for IRA – $6, 500; 401k – $ 24,000
  • If you withdraw funds from either IRA/401k before the age of 59 ½, the IRS will add 10% tax penalty along with income tax owed on the funds distributed. Some 401k plans allow you to access a portion of your 401k account in the form of a loan, which you are expected to pay back to yourself. If the amount is not returned, then it is considered as a withdrawal. You will be subject to the early withdrawal penalty depending on your age at the time of taking the loan. IRA does not allow loans.
  • An IRA account can be set up by anyone by themselves, but the 401k is a group retirement plan which is started by an employer. An entrepreneur or small businessmen can ask his business to set up an account for you. For an employee, the employer will set up a group plan to offer a 401k.
  • 401k is employer-sponsored while IRA is an Individual Retirement Account. Your IRA is yours it will not change, but the 401k stays with the employer. It is employer specific and can be rolled over into an IRA but not an IRA.

    Tax benefits and restrictions for both are the same. Other differences/similarities are:

    • IRA has income restrictions, 401k does not
    • 401k has loan provision, IRA does not
    • An employer can contribute towards the 401k, but not to an IRA
    • Both have Roth options
    • IRA can invest in anything including real estate, 401k is more restrictive

If you are planning to retire and create a retirement fund then you can include both IRA and 401k as they are both well-funded and now that you know the difference between 401k and IRA.

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