Two options available when it comes to saving for retirement are to invest in an Individual Retirement Account or a 401k. To be able to decide which of the two options are best for you, you need to have complete information on the comparison between the two. The similarities and differences between an IRA and a 401k will be the focus of this post.
What is an Individual Retirement Account?
An Individual Retirement Account IRA is a retirement savings account that offers tax advantage and enables people to save for retirement. You open an IRA account with an IRA provider usually a financial institution. The contribution made in an IRA is invested in different investment options. The good thing about IRA is the tax advantage the account enjoys. The Individual Retirement Account is of two types; the Roth IRA and the Traditional IRA. Both types of IRA account similar. The minor difference is that for you get no tax deduction on your contributions for the Roth IRA while the traditional IRA has a deduction from the contribution.
Also read: How to Open an IRA in 5 Steps
What is a 401k?
A 401k is an employer-sponsored retirement account that allowed employees in an organisation save for retirement. How does the 401k work? The employer in a company creates a 401k and outlines criteria for eligibility. Once an employee is eligible to contribute, a certain amount is automatically deducted from the employee’s paycheck periodically to fund the 401k account. The contributions in the 401k account are channelled into various investment options. The 401k account also enjoys a tax advantage.
Similarities Between an Individual Retirement Account IRA and a 401k
a. Retirement Account: The IRA and 401k have the same purpose. Both accounts are retirement accounts to help people save for retirement. Also, both types of accounts have an option to invest the contributions in the account for a higher return.
b. Tax Advantage: The IRA and 401k enjoy some tax advantage. In order words, the contribution and income generated from investments are not subject to tax. This means that, as long as you don’t withdraw from the account, the revenue generated from the account remains tax-free. This gives an advantage to earn more income. That includes investment gains, dividends, profits, and interests from investments.
Also read: How to Start a 401k As An Employee
c. Penalties for Early Withdrawals: Another similarity between an IRA and the 401k account is that both accounts come with a penalty. The penalty applies when you make an early withdrawal from the account. The law provides that no withdrawal should be made from both an Individual Retirement Account and 401k account until the contributor gets to 59.5 years. Any withdrawal made before that age is deemed to be an early withdrawal and comes with a penalty. The penalty for an early withdrawal from any of the account is 10% of the contribution made, and the current tax rate applies.
d. Limits to Amount you contribute: Also, there is a limit to the amount you can contribute to both an IRA and a 401k account. That means that there is a limit to the amount you can save in any of these retirement accounts in a year.
Differences between an IRA and a 401k Accounts:
1. Limits to Contributions:
It was mentioned earlier that there is a limit you can contribute to both an IRA and 401k. There is a difference in the limit for both accounts.
a. Individual Retirement Account: For an IRA, the limit to the amount you can contribute is $5,500 if you are below 50 and $6,500 if you are above 50 years.
b. 401k: While for 401k, the limit to the amount you can contribute is $18,000 if you are below 50 and $24,000 if you are above 50. The limit for 401k includes amount matched by your employer. You can see that the limit is in favour of the IRA account.
2. Employer Match:
Employer match is money given by an employer to match your contribution to a retirement account. In other words, employer match is free money to your account.
a. Individual Retirement Account: There is no provision for an employer match in an IRA.
b. 401k Account: An employer can match a 401k account. The amount matched depends on the discretion of the employer. This is one advantage that a 401k account has over an IRA.
3. Account Sponsor:
a. Individual Retirement Account: The IRA is an independent account. You don’t need an employer to sponsor the account. Anybody that earns an income can easily open an IRA account.
b. 401k: A 401k account must be sponsored by an employer for it to exist. In other words, without an employer, there would be no 401k. Also, the employer plays a significant role to play in a 401k. For instance, the employer decides who qualifies for a 401k in an organization.
a. Individual Retirement Account: You can’t take a loan from an IRA before you get to 59.5 years. You attract a penalty when you do so. The exception is if you are taking the loan to buy a home. In such instance, you are allowed to take up to $10,000 without penalty
c. 401k: You can easily take a loan from your 401k account. The loan is paid off from your paycheck.