Individual retirement accounts (IRAs) share many characteristics of retirement plan accounts like 401(k) accounts or Thrift Savings Plan accounts, but differ in many other ways.
The main similarities? Tax-deferred growth possibilities, as both forms of accounts generally offer tax-deferred earnings from interest income, dividends, and capital gains. They also offer the potential to reduce your income tax burden, though in different ways.
They both offer the possibility of taking hardship distributions for items like unreimbursed medical expenses, medical insurance, disability, qualified college expenses, and first-time home purchases. Generally, hardship distributions are limited to the amount of your contributions or deferrals. Some distributions are taxed and typically also incur a 10% early-withdrawal penalty if taken prior to the age of 59½.
The subtle, but important, differences between IRAs and 401(k) accounts arise when answering the questions below.
- Where do contributions come from and how are they handled from a tax standpoint?
- How are early distributions treated?
- When are federal taxes withheld automatically?
- When do Required Minimum Distributions (RMDs) begin?
IRA vs 401(k) contributions.
Contributions to traditional IRAs may be tax deductible. Contributions to Roth IRAs are not deductible.
Contributions to workplace retirement plan accounts — with the exception of Roth 401(k)s — are typically taken from pre-tax dollars, money taken from your paycheck prior to it being taxed.
IRA vs 401(k) distributions.
Distributions from traditional IRAs are subject to specific requirements. Generally, a distribution taken before the age of 59½ is subject to a 10% early distribution penalty. The penalty no longer applies once you reach 59½. However, all distributions are taxed as ordinary income. In the case of a Roth IRA, distributions made before age 59½ are not taxed or penalized provided the amount withdrawn is smaller than what you contributed. When you need money from your 401(k) or other retirement account — in a non-hardship situation — it must first pass through to an IRA (a rollover IRA) after you separate employment. At that point, it’s subject to normal terms of distributions from IRAs.
If you are remaining in your job, but would still like to access money in your 401(k) account, you may be able to borrow the needed funds. Many 401(k) plans offer loan provisions.
When you move money from your retirement plan directly to an IRA or another qualified retirement plan — and the transfer is direct from one account custodian to another — your investments are not subject to federal taxes. If the transfer is indirect, your investments are subject to a 20% federal tax withholding.
Qualifying distributions from a contributory or rollover IRA are subject to federal and state taxes as ordinary income after you reach age 59½.
If your investments are held in a Roth IRA, distributions of income, capital gains, and dividends are not taxed if you’re 59½ and your account has been open five years. Also, until you reach that age, distributions are untaxed as long as they don’t exceed your contribution total.
In the year you reach age 70½, your investments are subject to required minimum distributions (RMDs) unless they’re in a Roth IRA. RMD rules apply to all employer-sponsored retirement plans as well as traditional IRAs and IRA-based plans like SEPs and SIMPLE IRAs. RMD rules do not apply to Roth IRAs while the owner is alive. The amount of your RMD is determined largely by three things: your age, life expectancy conversion tables from the IRS, and the combined balance of your investments in qualified investment accounts.
One final thing: while many employers offer matching contributions to their employees’ retirement plan accounts, they don’t make matching contributions to their employees’ IRAs.