An IRA, short for "Individual Retirement Account", is an account that you can save money into for your retirement.
A 401(k) is also an account that you save money into for your retirement, but is sponsored by your employer, typically a private company.
"Sponsored by your employer" means that if you enroll in your company's 401(k), they will provide the investment options, fiduciary responsibility, and the mechanics to save into this account straight from your paycheck.
With both accounts, you can write off your contributions, enjoy tax-deferred growth, and pay taxes when you take the money out in retirement, but there are some key differences.
Key Differences:
1. Contribution limits for an IRA are lower than they are for a 401(k).
With an IRA, you can contribute up to $6,000 (2021, if younger than 50), or up to $7,000 (2021, if 50 or older).
With a 401(k), you can contribute up to $19,500 (2021, if younger than 50), or up to $25,000 (2021, if 50 or older).
What does this mean?
You are capped at a lower contribution limit with an IRA. Even if you were able to save more than the limit, you would have to find another type of account to save into that might not have the same tax benefits. If you don't think you'll contribute more than $6,000 in a year, this might not be a key difference that's as important to consider. If you are looking to save heavily into your retirement account, a 401(k) might be better suited for you so you can put away more.
2. There are income limits you must consider with an IRA , while there are no income limits with a 401(k).
What does this mean?
While it's obviously great to make a lot of money, if you make over a certain amount set by the IRS, you might not be eligible to add to an IRA AND write off your contributions from your taxable income in the year that you contribute. (Note: these income limits only apply if you or your spouse is covered by a retirement plan at work and you're considering contributing to an IRA). If you file single and make more than $140k, you are not eligible to write off your contributions. If you file a joint return and make more than $208k, you are not eligible to write off your contributions.
If you make above those limits and the company you work with offers a 401(k), a 401(k) might be a better option.
3. There is no employer match (aka "free money") with an IRA, while there is often an employer match with a 401(k), depending on your employer.
What does this mean?
An IRA is funded by your own money. Sometimes, private companies like to incentivize their employees to save, which helps to attract and retain quality workers, so they provide an "employer match" that gets deposited into their 401k. This could help the account grow faster just because there is more money being invested.
4. When it comes to managing your account, there is more flexibility with an IRA, while you have to work within certain parameters set by your employer with a 401(k).
What does this mean?
With an IRA, you have unlimited options when it comes to the investment provider you want to use. With a 401(k) you must choose from the more limited menu of investment options that your employer establishes. The menu of options might be good, but you are just more limited compared to having access to any investment vehicle out there on the market.
5. Although both accounts are earmarked for retirement, access to an IRA versus a 401(k) before age 59 1/2 is different.
What does this mean?
With an IRA, if you need to access your funds before age 59 1/2 , you will have to pay federal and state income taxes, plus a 10% penalty to do so. You cannot "repay" any distributions back into your IRA.
With a 401(k), you can access your funds in the form of a loan without incurring taxes and a penalty, assuming you pay the loan back on time.
Main Takeaway
Both an IRA and a 401(k) are great vehicles to save into!
You'll just want to make sure you're using the one that makes the most sense for you.
Let us know how we can help!
In good health,
Tori