In this article, you will find information about the differences between an Individual Retirement Account (IRA) and a 401(k) account, which are two common types of retirement accounts that offer tax advantages when investing. The main difference between them is that an IRA is a type of retirement account that you open, fund, and invest in on your own, while a 401(k) is a retirement account that you open through your employer. If you want to learn more about the differences between an IRA and a 401(k), you are in the right place. Discover more about how each type of retirement account works, who can contribute to them, and which one might be right for you.
What is the difference between IRA and 401(k)?
An IRA is a tax-advantaged retirement account that stands for “Individual Retirement Arrangement,” although it is commonly referred to as an individual retirement account. Typically, an IRA is an account you open for yourself as an individual. However, some types of IRAs, such as Simplified Employee Pension (SEP) or Savings Incentive Match Plan for Employees (SIMPLE) IRA, allow an employer to open and fund an account on your behalf.
A 401(k) is a type of retirement savings plan that employers can set up on behalf of their employees. Like an IRA, you receive tax benefits for saving in a 401(k). Some companies also contribute to employees’ accounts – known as employer contributions. A 401(k) operates under the rules of the Employee Retirement Income Security Act (ERISA), which is a federal law that sets minimum standards for retirement plans in the private sector workplace.
The tax advantages you receive with an IRA versus a 401(k) depend on the type of account, and the withdrawal rules differ. However, if you withdraw money from either account before age 59 and a half, you may be subject to taxes and a 10% penalty.
Types of IRA
There are two main types of IRAs:
Traditional IRA
A traditional IRA is an IRA that allows you to make tax-deductible contributions based on your income and filing status and whether you are covered by a retirement plan at work. Your money grows on a tax-deferred basis and is generally taxed when withdrawn.
Roth IRA
A Roth IRA is a type of IRA that is funded with after-tax dollars. Although you cannot deduct your contributions for tax purposes, your withdrawals are tax-free in retirement if you follow certain rules. You may also be subject to a penalty if you withdraw your earnings early, although you can access your contributions at any time without taxes or penalties.
Tax Treatment of 401(k)
With a 401(k), you defer a portion of your salary or income to your retirement account, which is typically invested in a mix of bond funds or mutual funds. However, the tax treatment can differ depending on the type of 401(k) plan.
Traditional 401(k)
– Pre-tax contributions: Your contributions are made pre-tax or before taxes are deducted from your paycheck, which can reduce your taxable income in the year of contribution.
– Tax-deferred growth: Once your balance is invested over the years, it grows tax-deferred, meaning you do not pay any taxes on investment income.
– Taxable withdrawals: Any withdrawals or distributions in retirement are taxed at your income tax rate at that time.
Roth 401(k)
– After-tax contributions: A Roth 401(k) is similar to a traditional 401(k) but with a different tax treatment. Contributions are made after-tax or after tax has been deducted from your paycheck. In other words, you do not get a pre-tax deduction from your taxable income when you contribute.
– Tax-free growth: Once you invest your balance over the years, you do not pay any taxes on the earnings in retirement.
– Tax-free distributions: With a Roth 401(k), you do not pay any taxes on withdrawals in retirement as long as you are at least 59 and a half years old and have maintained the account for at least five years. However, if you received contributions from your employer through a matching program, those must be kept in a separate account and are subject to taxes upon distribution.
According to a 2020 survey by the American Retirement Association and Profit Sharing Council, nearly 90% of 401(k) plans offer a Roth option for employee contributions.
Eligibility
To contribute to an IRA, you must have earned income for the tax year. Earned income simply means the money you earn from work, such as wages, salary, bonuses, tips, and self-employment income. Investment income and Social Security benefits, unemployment benefits, and pension income do not count. There are also income limits for a Roth IRA.
If you are married and file a joint tax return, you are also allowed to fund an IRA for your spouse, even if they have little or no earned income. You can contribute up to the contribution limit multiplied by two or your community income for the tax year through what is commonly referred to as a “spousal IRA.”
You can only contribute to a 401(k) if your employer offers this option. Generally, employers must allow employees to participate in the plan if they are at least 21 years old and have at least one year of service. Employers can set their own rules in their plan document, but the rules cannot be more restrictive.
Contribution Limits
IRAs and 401(k)s are subject to different annual contribution limits, which are set by the IRS, limiting the amount you can contribute each year.
IRA Contribution Limits
The IRA contribution limit for 2022 is $6,000 ($6,500 in 2023) if you are under 50 years old. If you are 50 years old or older, you are allowed to make an additional contribution of $1,000 for both 2022 and 2023. The limits apply to both traditional IRAs and Roth IRAs.
You can only contribute up to the amount of earned income you have for the year. If you only earn $4,000 in 2022, the maximum contribution for the year will be $4,000.
Note: You have until tax day to make your contribution to an IRA for any given year. For example, the deadline to fund your IRA for 2022 is April 18, 2023.
401(k) Contribution Limits
The annual contribution limit for a 401(k) is $20,500 in 2022 ($22,500 in 2023). You can make an additional contribution of $6,500 in 2022 ($7,500 in 2023) if you are 50 years old or older.
Contributions from both the employer and employee cannot exceed $61,000 in 2022 ($66,000 in 2023) or 100% of the employee’s total salary. However, the additional contribution does not count toward this limit.
Other Considerations
An IRA offers more flexibility compared to a 401(k). You can open an IRA with a broker of your choice. You can invest in any individual stocks, bonds, mutual funds, or exchange-traded funds (ETFs) offered by your brokerage firm.
You can only invest in a 401(k) through your employer. Your account is managed by a third-party administrator chosen by your company. Your investment options are more limited, although most
Source: https://www.thebalancemoney.com/ira-vs-401k-whats-the-difference-5221705
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