There are some common misconceptions about the differences between an IRA and a 401k. While these two are very similar there are some distinct differences that make each unique.
Before we tackle the differences between an IRA and a 401k its important to note that these are not investments. They are accounts. Just because you have an account open does not mean you have investment that will grow and help fund your retirement. Much the same way that just because you own a refrigerator doesn’t mean you actually have any food in it.
To continue with this analogy… in your fridge you can have a variety of different types of food (juice, pickles, eggs, beer, and anchovies- if you’re into that sort of a thing). In an IRA and 401k you can have different investments too. Such as stocks, bonds, mutual funds, etfs, commodities, real estate, and more. You can also change or “throw out” the Investments in your IRA or 401k if you’ve left them in that back of the fridge for too long. You know like that 3lb. jar of mayo you bought for that party that one time.
Now that you are hungry, lets get to the meat of it, how they are similar?
- Both allow you put money in on a tax deferred basis. Meaning that taxes are not due at the time when you add money. For example, if you make $50,000 and decide to invest $2,000 of it into your IRA or 401k, the $2,000 is not going to be part of your taxable income.
- Your money within an IRA or 401k can be invested in a variety of ways.
- The money that is invested is allowed to grow tax deferred. You do not have to pay taxes on the gains from your investments until you take the money out. If you make $1,000 off of your $2,000 investment, you now have $3,000 in your account and you will not have to pay taxes on that gain until you withdrawal the money.
- When you do withdrawal the money for whatever amount it will be considered part of your taxable income. You will own taxes on the withdrawal amount. Let’s say you withdrawal the $2,000 and your current annual income is $50,000 after the withdrawal your taxable income will be $52,000.
- Since an IRA and 401k are designed for retirement the money that you invest is not supposed to withdrawn until after the age of 59 ½. You read that correctly -the government added in a half, well, because your inner 6-year-old knows it’s that important. If you withdrawal the money prior to 59 ½ you will pay a 10% penalty on the money plus the amount withdrawn is now part of your taxable income.
- Also, the government mandates that at age 71 ½ (again the half) you have to take out a Required Minimum Distribution (RMD). Basically, they tell you the amount that you must pay taxes on. Quick note, if you are still employed at age 71 ½ and not the owner you can delay your RMDs.
While an IRA and a 401k have many similarities, they do differ is a few very key areas. The main one being that an IRA is Individual Retirement Account, so it is your and yours alone. And anyone can have one. While a 401k is company sponsored, so you can only participate in it if your employer offers one. Or, if you are the owner and created one. Some other key differences are:
So, which is right for you? It depends. If you have the option of putting your money into an employer-sponsored 401k or an IRA you should do both. Max them out if possible. We recommend prioritizing the 401k first and then adding to the IRA if you are within the income limits.
This hopefully gives you a good overview of the differences between an IRA and 401k. While there are many factors to consider, the most important thing to remember is that both are great tools to use to help achieve your retirement goals.
We’ll plan to discuss how Roth IRA’s and various other types of 401k options might work for you soon, but in the meantime if you’d like a personalized recommendation please reach out to us as we are always happy to help!