Similarities and Distinctions Between 401k and IRA

Occasionally, I get the question, “What’s the difference between a 401k and IRA?”  To this question, I have penned a few similarities and some differences as well.  

Similarities between a 401k and a Traditional IRA:

1. Tax Deductibility.  Both 401k’s and IRA’s are generally eligible for tax deductions to the extent that contributions are made into the account.  In the case of a 401k, “deferrals” are deducted from an employee’s wages and deposited into the employee’s individual account.  For IRA’s, checks are generally cut from an individual’s bank account.  Either way, the effect is the same.  Contributions reduce taxable income thereby reducing net income tax.
2. Tax Deferral.  Tax deferral is the concept of delaying the payment of income tax on the growth of the principle amount contributed.  Dividends, interest, and gains are not taxed as long as the funds remain within the account.  This is true for both 401k’s or IRA’s.
3. Investment Choices.  Once the funds are in the 401k or IRA, several investment choices are usually available.  Although a larger range of choices is available to an IRA owner, either account usually offers the same type of investment choices.  Stocks, bonds, funds and cash are almost always the investment types available.  In 401k’s, company stock is often offered to 401k participants.
4. Taxable Withdrawals.  When withdrawals are made from retirement accounts, the funds are taxed at ordinary income tax rates.  Also, funds are taxed at ordinary income tax rates regardless of when they are withdrawn.  Fundamentally, taxable withdrawals are treated the same for both IRA's and 401k's.
   
5. Penalized Early Withdrawals.  Both 401k’s and IRA’s obligate the account-holder to keep the funds in the account once contributed.  The IRS has determined that if individuals are to get tax advantages through the use of retirement accounts, certain rules should be followed.  Both accounts require that (with few exceptions) funds should stay in the account until the age of 59½.  If penalized for an early withdrawal on either a 401k or a Traditional IRA, the rate is 10% on the amount withdrawn.

Differences between a 401k and an IRA:

1. Sponsorship.  The primary difference between a 401k and an IRA is that a 401k is a company sponsored plan whereas an IRA is a self-directed account.  Although the employee is ultimately responsible for his/her final 401k portfolio, it is the employer that offers the choices from which to create that portfolio.  A traditional IRA, however, is the design of the individual from start to finish.  Although the account-owner may hire out the advisory services of the IRA account, the ultimate responsibility for fund choices, contributions, and withdrawals rests with the account-owner.
2. Investment Choices.  Typically, the employer makes the selection on which funds to ultimately allow in a 401k.  On the other hand, IRA account-holders typically have unlimited choices with which to invest.  Therefore, IRA choices are much larger than those found in a 401k.  
3. Accessibility.  As mentioned above, withdrawals on either account are penalized at a rate of 10%.  But, un-reimbursed medical expenses, first-time home-buyers, and higher education expenses may offer IRA account-holders the opportunity for withdrawals from their account without a 10% penalty applied.  401k’s do not offer these exceptions to the 10% penalty.
4. Contribution Limits.  401k’s offer far greater deductible contributions on an annual basis.  For 2011, maximum 401k contributions are $16,500.  For participants more than 50 years old, the amount jumps to an annual amount of $22,000.  Maximum IRA contributions for 2011 are $5,000 per year.  For individuals older than 50, the amount jumps to $6,000.  All of these amounts will remain the same for 2012 except for possible inflation adjustments.  2012 contribution maximums were increased by the IRS in October of 2011.  The new limit is now set at $17,000 for 2012, with the catch-up of $5,500 remaining the same as in 2010 - $5,500.
   

As you can see, there are not only differences between a 401k and an IRA, there are many similarities.  This list is not exhaustive, but it should give you a foundation for the most basic distinctions between the two types of retirement accounts.

 

401kFundAdvice is an investment advisory firm offering investment advice on all types of investment accounts.