Explain the difference between a 401k and an IRA

401k and IRA difference accounting

401(k) is a retirement account sponsored by your employer. On the other hand, IRA (Individual Retirement Accounts) is an investment account that you open with an IRA provider. An IRA provider can be your bank or a broker. 401k plans and IRA are used to save for your retirements. You can save in both the options at the same time. Both offer good tax benefits. Let us understand their differences in detail in the sections below.

Understanding 401(k)

Saving in 401(k) is limited with your employer only. You have to talk to your employer to set up a 401(k) plan. You and your employer both contribute to this account. Contribution of your employer often depends on their generosity. It can be 100% or lower than that. 100% employer contribution is also called 401(k) employer match.

401(k) plans can be traditional or Roth. Differences among these are based on the way taxes are considered. In traditional 401(k), taxes are deducted after contribution to the account. But in Roth 401(k), taxes are deducted before contribution. Benefit of Roth 401(k) is that you don’t have to pay taxes when you withdraw your money at the time of retirement.

You can contribute to traditional 401(k) in a given year to reduce your taxable income for that year. But there is a limit to the amount you can put in 401(k). For the year 2020, you can contribute $19,500, if your age is below 50 years, and $26,000, if above.

401(k) plans are usually portable. This means that you can take the account with you if you switch jobs. However, your account might have a vesting schedule. This means that the employer contributions are not vested immediately. They are vested over time, usually over 5 years.

Understanding IRA

Using IRA, you can invest in bonds, stocks, and various assets. An IRA account with a bank can get you savings accounts and Certificates of Deposit. On the other hand, if you open an IRA account with a broker, you can invest in stocks and bonds. If your age is below 50 years, you can contribute only $6,000 in your IRA account for 2020 or 2019. If you are above 50 years, you can contribute $7,000.

There are two popular IRAs: Traditional IRA and Roth IRA. If you invest in a traditional IRA, you will get a reduced tax bill in the year you are contributing. If you invest in Roth IRA, you will not get tax-deduction. But your investments will grow without any taxes. Additionally, when you withdraw your money in retirement, it will be tax free.

Unlike 401(k), you can withdraw your IRA contribution at any time. A demerit with the IRA is that the contribution is lower than that of 401(k).

IRA offers more investment options than 401(k) and the investment options are not limited to stocks and bonds. You can invest in real estate, art, and other alternative assets.

401(k) is portable only if your employer offers it. If you switch jobs, you have to leave the account behind. But with IRA, you can take the account with you wherever you go.

Tip: If your employer contributes a matching amount to your 401(k), then fund it first, then focus on IRA investment. If your employer does not offer matching contribution, then focus on maxing out your IRA first. Now, you get the difference between 401k and an IRA.

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