Individuals interested in saving for retirement often face a plethora of choices. In the United States, the two most popular retirement savings vehicles are 401K accounts and individual retirement accounts, or IRAs. Although the accounts share some similarities — both are defined by national law as vehicles for retirement savings, for instance, and both have certain tax advantages — there are also some significant differences, particularly when it comes to contribution schedule, withdrawal policies, and tax penalties.
The most basic difference between IRA and 401K accounts is how they can be opened and how contributions must be made. 401K accounts can traditionally only be offered by employers. In most cases, they are employer-managed accounts that employees contribute to via paycheck deduction. Employees often have some choice with respect to how 401K dollars are to be invested, but most of the time, the plan administrators limit that choice to a handful of stocks, mutual funds, and other long-term investment vehicles.
Many employers also offer to match employee contributions, usually as a way of encouraging savings. Because employees contribute to their 401K accounts directly from their paychecks, deposits are typically made with pre-tax dollars. This can be advantageous because it allows the account to begin with a larger principal, which can enable more growth. Taxes will apply to the 401K when the funds are accessed, but this is usually not until the investor reaches retirement age.
An IRA, on the other hand, is a wholly independent investment account that is usually set up by a private investment firm. Investors have liberty to invest IRA funds in almost any combination of funds, stocks, or bonds. Some investment firms charge transaction fees for switching funds around or making changes to account allocations, but not all do.
The tax implications of an IRA and 401K are also quite different. IRAs are generally funded with after-tax dollars, though in most cases, contributions to a traditional IRA account are tax deductible for the year in which they were made. Many investors contribute to IRAs as a means of shifting or reducing their tax burden, though all IRAs have maximum annual contribution amounts that are set by law. Like a 401K, taxes will apply to IRA funds once they are distributed. As such, both IRA and 401K funds are means of tax deferment, not tax avoidance.
Not all IRAs are tax-deferred, however. A special subset of IRA, the Roth IRA, is a retirement account option that allows investors to invest after-tax dollars but take no deduction, essentially allowing accounts to grow tax-free from that point. When funds from a Roth IRA are distributed, no taxes are due, since taxes were already paid.
The accessibility of funds can differ between traditional IRAs, Roth IRAs, and 401Ks. Money in either form of IRA is generally very difficult to access before retirement. It can be done, but requires significant administrative undertaking, as well as a tax hit for a traditional account, and penalties for a Roth account.
With a 401K, the money is usually available with little more than a petition to the plan administrator. Both the administrator and the government usually assess steep fees for early withdrawal, but withdrawal is relatively simple. Taxes, of course, also apply once 401K funds are withdrawn.
Many investors have both 401K accounts with their employers and IRA accounts that they hold in their personal capacities. By keeping both IRA and 401K portfolios, investors are able to balance the costs benefits of each type of plan. Investment advisers frequently recommend a diversity of investment strategies, and often at least two retirement savings vehicles. The IRA and 401K options, though they have their differences, are two of the easiest and most popular to use.