When it comes to retirement plan in the United States, various options exist. Rather than simply wait on a pension fund to materialise, there are various investment options for you that could as much as double your savings. However, the availability of multiple options may leave one slightly confused. First there is the concept of IRA. IRA stands for “Individual Retirement Account” and is a type of savings account that is designed to help you save for retirement. Generally, it offers many tax advantages and it is broken down into two different types known as Traditional IRA and Roth IRA.
Next, there is also the concept of 401k. A 401(k) plan is the tax-qualified, defined-contribution pension account defined in subsection 401(k) of the Internal Revenue Code. Basically, under the plan, retirement savings contributions are provided by an employer, and deducted from the employee’s salary before taxation. In other words, it is tax-deferred until withdrawn after retirement or as otherwise permitted by law. It is also divided into Traditional 401(k) and Roth 401(k). Choosing between these plans is where most of the conflict comes up. There is need to understand the difference between an IRA contribution plan as against a 401k plan. For ease of understanding, comparison would be made between a traditional IRA Contribution and a traditional 401(k) plan. Here are some notable differences:
Definition and Scope of A Traditional IRA Contribution and A Traditional 401(k) plan
A Traditional IRA Contribution is a process with which you contribute pre-tax or after-tax dollars, and which allows your money to grow tax-deferred. Basically, when you make withdrawals after age 59½, they are treated as current income. In traditional IRA Contribution, any person that earns income in any way, can contribute to a Traditional IRA. However, there are contribution limits as some contributions may be tax deductible.
A Traditional 401(k) plan on the other hand is an employer-sponsored plan that gives employees a choice of investment options. It is a qualified employer-established plan to which eligible employees may make salary deferral contributions on a post-tax and/or pre-tax basis. Employee contributions to a 401(k) plan and any earnings from the investments are tax-deferred. More-so, you would only pay the taxes on contributions and earnings when the retirement savings are withdrawn.
For both IRA and 401k, there are distinct rules for participation and eligibility. In traditional IRA contribution, as long as you are under the age of 70 and who you earn an income, you can participate in it. Most people of working age can open an IRA. You can also make an IRA contribution for spouse. All you have to do is you file a joint tax return for the spouse and as long as your income is more than the contribution, he or she benefits.
However, for a 401(k) plan, there is no such deal. You must work for an employer who provides a 401(k) plan for its employees to have a 401(k) account. 401(k) plans are more of benefits than contributions, hence, an employer can place limitations on who can participate and when he or she can. So, only people who are employed by companies that participate in 401(k) plans are eligible to make 401(k) investments.
An IRA Contribution is directly associated with the Individual; as such, only he or she makes contributions to his or hers IRA Contribution account. On the flip side, a 401(k) plan is a benefit that accrues to the employees from the employer – it is an employer-provided plan. The employers elect to match a pre-defined percentage of each employee’s individual 401(k) contribution. So basically, for your contribution, you get free ‘bonus’ money added to it as well. Definitely a cool deal.
When it comes to taxes, both plans have both differences and similarities. Traditional IRAs are typically tax deductible if neither you nor your spouse are covered by a work retirement plan such as a 401(k). IRA Contribution offers tax-deferred growth on your investments, so the assets in the IRA will not be taxed until they are withdrawn. These funds go into a tax-deferred retirement plan account and can be set up at any time.
A traditional IRA may also offer tax-deductible contributions for people who do not participate in an employer-sponsored plan but Roth IRA provides the opposite. Contributions may be tax-deductible subject to income limits and finally, the gains in the account are not taxed.
A 401(k) plan can take either pre-tax or post-tax pay check contributions, and the earnings are tax-deferred until you begin making withdrawals. All the money you contribute to your 401(k) account is pre-tax money, meaning you will not be taxed until you withdraw it upon retirement. Gains in the account are also not taxed. 401k also has higher allowances for tax-deferred savings and you can also take advantage of the employer matching.
For loans, an IRA Contribution does not permit it. In fact, IRAs do not generally permit loans or penalty-free distributions before age 59. ½, but account holders may be permitted to take up to $10,000 without penalty if they are using it to buy their first home.
A typical 401(k) plan permits a certain degree of loan taking. When still employed with employer setting up the 401(k), loans may be available depending upon the plan, not more than 50% of balance or $50,000. An employee may be permitted to take loans or certain hardship withdrawals from a 401(k). Loan repayments are generally taken from the employee’s pay check.
Asides the above, there are also certain similarities between the both of them. They include:
- Both accounts are protected from bankruptcy
- Individuals must start withdrawing funds at age 70½ unless still in employment
- Distributions can begin at age 59½
- Both IRAs and 401ks can help you achieve your retirement savings goals
- Withdrawals are taxed as ordinary income
- 10% penalty plus taxes for early withdrawals
After proper analysis of both plans, you can choose whether to opt for IRA Contributions and 401(k) plans. Luckily, there are options to do both or swap after a period of time.