Individual retirement accounts (IRAs) have a lot in common with employer-sponsored retirement plan accounts like 401(k)s, but differ in many important ways. Let’s take a look.
IRA vs 401(k): How are they alike?
The main similarities include tax-deferred growth possibilities, as both traditional IRAs and 401(k)s generally offer tax-deferred earnings from interest income, dividends, and capital gains. They also offer the potential to reduce your income tax burden, although in different ways.
Both may also offer the possibility of taking hardship distributions for items like unreimbursed medical expenses, medical insurance, disability, qualified college expenses, or 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.
IRA vs 401(k): How are they different?
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?
There are additional differences when comparing a traditional IRA to a Roth IRA.
IRA vs 401(k): Contributions.
IRAs: You can contribute $5,500 to an IRA each year ($6,500 if you’re 50 or older) in 2017 and 2018.1 However, there are income restrictions that determine whether or not you can contribute to a Roth IRA. Depending on your income, tax-filing status, and other factors, you may be able to deduct all or some of your contributions to a traditional IRA. These contributions then grow on a tax-deferred basis. Contributions to Roth IRAs are not deductible.
401(k): Contributions to employer-sponsored retirement plan accounts — with the exception of Roth 401(k)s — are typically made with pre-tax dollars, that is, money taken from your paycheck before being taxed. The contribution limits on 401(k)s and other employer-sponsored plans are fairly high — in 2018, you can put in up to $18,500 if you’re under 50 years old and up to $24,500 if you’re 50 or older.2
IRA vs 401(k): Early distributions.
IRA: 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.
401(k): Distribution options from a 401(k) plan vary based on your age and employment status. Unlike an IRA, you can’t take a distribution from a 401(k) whenever you feel like it. To take out money, you need to have what’s called a “distributable event,” such as leaving your employer or retiring.
When you leave an employer or retire, you have to decide what to do with the money in your 401(k). Generally speaking, you can 1). roll the money over into an IRA or another employer-sponsored retirement plan, 2). take a “lump-sum” distribution (that is, “cash out” your account), or 3). do nothing, and leave the money in your former employer’s plan. If you cash out your plan, that money will be taxed as regular income in the year you take the distribution. Like the traditional IRA, pre-tax 401(k) contributions taken before age 59½ may be subject to a 10% early withdrawal penalty.
If you haven’t had a distributable event, but still want to access money in your 401(k) account, you may be able to borrow the needed funds. Many, but not all, 401(k) plans offer loan provisions. If you qualify for a hardship distribution, this may also be an option under your plan.
IRA vs 401(k): Federal taxes.
IRA: Distributions from a traditional 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 or older and your account has been open for at least five years. Also, until you reach that age, distributions are untaxed as long as they don’t exceed your contribution total.
401(k): A lump sum distribution from an employer-sponsored retirement plan is subject to mandatory 20% federal tax withholding. The amount of the distribution will be considered part of your ordinary income for that year. When you roll money over from your retirement plan directly to an IRA or another qualified retirement plan — and the transfer is made directly from one account custodian to another — your investments will not be subject to federal taxes at the time of transfer. The money will remain tax-deferred until the time you withdraw it from the rollover IRA or retirement plan.
IRA and 401(k): RMDs.
In the year you reach age 70½, tax-deferred retirement accounts are subject to required minimum distributions (RMDs). RMD rules apply to all employer-sponsored retirement plans as well as traditional IRAs and IRA-based plans like SEPs and SIMPLE IRAs. The one exception is Roth IRAs. RMD rules do not apply to Roth IRAs while the owner is alive. They do, however, apply to Roth 401(k) accounts.
The amount of your RMD is determined largely by three things:
- Your age.
- The life expectancy conversion tables from the IRS.
- The combined balance of your investments in qualified investment accounts.
One final thing to keep in mind: while many employers offer matching contributions to their employees’ retirement plan accounts, they don’t make matching contributions to their employees’ IRAs.
As you can see, there are a lot of similarities and subtle differences between the various types of retirement accounts. Be sure to understand the consequences of any distribution decisions you make for your own accounts. If you need assistance, a reputable financial advisor or tax professional can help you make a plan for your unique situation.