The biggest difference between two most popular types of retirement accounts — 401(k) and IRA — is that 401(k) plans are set up by employers and IRAs are individual retirement accounts, thus the acronym. With 401(k) accounts, contributions are made on a pre-tax basis. Contributions to IRA accounts are made with post-tax income but tax deductions are available for these contributions. With both IRA and 401(k), investments grow on a tax-deferred basis but at the time of withdrawal, taxes are due at the then-current tax rate.
There are different contribution limits and tax considerations for both types of plans, as explained below.
|Changing Institutions||Can roll over to another employer's 401(k) plan or to an (traditional) IRA at an independent institution||Funds can be either transferred to another institution or they can be sent to the owner of the traditional IRA who has 60 days to put the money in another institution in a rollover contribution to another traditional IRA.|
|Plan set by||Employer||Individual|
|Conversions||Upon termination of employment, can be rolled to IRA or Roth IRA. When rolled to a Roth IRA taxes need to be paid during the year of the conversion||Can be converted to a Roth IRA. Taxes need to be paid during the year of the conversion. Other limitations may also apply.|
|Early Withdrawal||10% penalty plus taxes including withdrawal for hardships||10% penalty plus taxes for distributions before age 59 1/2 with exceptions|
|Contribution Limits||2015:$18K (under 50 yrs old), $24K (50+); 2014: $17.5k (under 50), $23K (50+); limits apply to combined total contributed to 401(k) and Roth 401(k). Employee and employer combined contributions must be lesser of 100% of employee's salary or $53k||$5.5k/yr for age 49 or below; $6.5k/yr for age 50 or above in 2013; limits are total for trad IRA and Roth IRA contributions combined|
|Education Expenses||Payment of secondary educational expenses in last 12 months for employee, spouse, or dependents subject to 10% penalty||Can withdraw for qualified education expenses of owner, children, and grandchildren|
|Distributions||Distributions can begin at age 59 1/2 or earlier if owner becomes disabled.||Distributions can begin at age 59 1/2 or owner becomes disabled|
|Forced Distributions||Must start withdrawing funds at age 70 1/2 unless employee is still employed. Penalty is 50% of minimum distribution||Must start withdrawing funds at age 70 1/2 unless employee is still employed. Penalty is 50% of minimum distribution|
|Income Limits||Generally none, but somewhat complicated due to HCE (highly compensated employees) rules||Based upon MAGI; Single, HoH, MFS: full contrib to $52k, partial to $62k; MFJ; QW: full contrib to $83k, partial to $103k; can't contribute more than you make in that year|
|Investments within the accounts||Stocks, Bonds, Mutual Funds||Stocks, Bonds, Mutual Funds, Real Estate (Only in specfic types of IRA's)|
|Medical Expenses||Medical expenses not covered by insurance for employee, spouse, or dependents subject to 10% penalty||Can withdraw for qualified unreimbursed medical expenses that are more than 7.5% of AGI; medical insurance during period of unemployment; during disability|
|Home Down Payment||Purchase of primary residence and avoidance of foreclosure or eviction of primary residence is subject to 10% penalty||Can withdraw up to $10k for a first time home purchase down payment with stipulations|
|Inside the Account||Capital gains, dividends, and interest within account incur no tax liability.||Capital gains, dividends, and interest within account incur no tax liability.|
|Tax Implications||Money is deposited as "tax deferred" and then taxed at normal income bracket for distributions||Contributed money is at first post tax money. However, contributions are tax deductible which reduce your tax basis for that tax year. Then, distributions are taxed at the normal income for distributions|
|Contribution Withdrawal||No, but loans from this plan are available depending upon employer's plan||No|
History of 401(k) plans and IRA
In 1978, the United States Congress amended the Internal Revenue Code to add section 401(k). Work on developing the first plans began in 1979. Originally intended for executives, section 401(k) plans proved popular with workers at all levels because it had higher yearly contribution limits than the Individual Retirement Account (IRA); it usually came with a company match, and provided greater flexibility in some ways than the IRA, often providing loans and, if applicable, offered the employer's stock as an investment choice. Several major corporations amended existing defined contribution plans immediately following the publication of IRS proposed regulations in 1981.
A primary reason for the explosion of 401(k) plans is that such plans are cheaper for employers to maintain than a pension because, instead of required pension contributions, they only have to pay plan administration and support costs if they elect not to match employee contributions or make profit sharing contributions. In addition, some or all of the plan administration costs can be passed on to plan participants. In years with strong profits employers can make matching or profit sharing contributions, and reduce or eliminate them in poor years. Thus, unlike the IRA, 401(k) creates a predictable cost for employers, while the cost of defined benefit plans can vary unpredictably every year.
What are 401(k) & IRA?
401(k) is a type of employer-sponsored retirement plan in the US and some other countries, named after a section of the U.S. Internal Revenue Code. The 401(k) plan allows employees to save for retirement while deferring income taxes on the saved money and earnings until withdrawal. The employee chooses to have a portion of his or her salary paid directly, or "deferred", into his or her 401(k) account. In participant-directed plans (the most common option), the employee can select from a number of investment options, usually an assortment or mix of mutual funds that emphasize stocks, bonds, money market investments. Many companies' 401(k) plans also offer the option to purchase the company's stock. The employee can generally re-allocate money among these investment choices at any time. In the trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan's assets will be invested.
Individual Retirement Account (IRA) is a retirement plan account that provides some tax advantages for retirement savings in the US. The individual retirement arrangement and related vehicles were created by amendments to the Internal Revenue Code of 1954 (as amended) made by the Employee Retirement Income Security Act of 1974 (ERISA), which enacted (among other things) Internal Revenue Code sections 219 (26 U.S.C. § 219) and 408 (26 U.S.C. § 408) relating to IRAs.
Authorized income levels for 401(k) and IRA
401(k) has no regulations on income levels for the LCE & MCE, but the regulations for HCE (highly compensated employees are defined as employees with compensation of $100,000 or greater in 2006 and remains unchanged for 2007) greatly complicate it. The IRA, is based upon MAGI; Single, HoH, MFS: full contrib to $52k, partial to $62k; MFJ; QW: full contrib to $83k, partial to $103k; with the only regulation being one can't contribute more than he/she makes in that year
Differences in Withdrawal Options
While the IRA does not allow any kind of contribution withdrawls, the 401(k), though it doesn’t allow contribution withdrawals either, has the provision for loans from the plan depending upon the employer’s choice of plan. For early withdrawals, 401(k) attracts a 10% penalty plus taxes including withdrawal for hardships and the IRA attracts 10% penalty plus taxes for distributions before age 59 1/2 with exceptions. Other benefits like purchase of primary home (with a 10% penalty for avoidance of foreclosure or eviction of primary residence in 401(k) & a limit of upto $10k with stipulations), Payment of secondary educational expenses (subject to 10% penalty in 401(k)) in last 12 months for employee, spouse, or dependants(children & grandchildren included in IRA), for qualified medical expenses that are uninsured/unreimbursed for the employee, spouse & dependents (subject to 10% penalty in 401(k) & for amounts more than 7.5% of AGI; medical insurance during period of unemployment; during disability in IRA)
Differences with the Roth schemes
With the enactment of the Roth provisions, participants in 401(k) plans that have the proper amendments can allocate some or all of their contributions to a separate designated Roth account, commonly known as a Roth 401(k). Qualified distributions from a designated Roth account are tax free, while contributions to them are on an after-tax basis (i.e., income tax is paid or withheld on the income in the year contributed). In addition to Roth and pre-tax contributions, some participants may have after-tax contributions in their 401(k) accounts. The after-tax contributions are treated as after-tax basis and may be withdrawn without tax. The growth on after-tax amounts not in a designated Roth account are taxed as ordinary income.
The decision between choosing a Roth IRA vs. a Traditional IRA depends mostly on whether you are likely to be in a higher tax bracket in the future (in which case a Roth IRA is better) or a lower tax bracket in the future (in which case a conventional IRA is better). Roth IRAs also have a bit more flexibility in terms of early withdrawal. If your tax bracket does not change while you are working vs. when you retire, you will end up with the same amount of money in a Roth IRA as a conventional IRA for a donation less than the maximum allowable. If you save the maximum allowable amount in an IRA, and you stay in the same tax bracket, there is a slight tax advantage to the Roth-IRA.