401(k)s vs IRAs: What Are They and How Are They Different

For job seekers there are many factors to consider when it comes to potential job offerings from a new employer – compensation, workplace culture, location, benefits package, etc. 

There is, however, some things that most job candidates have come to expect from any employer, one such being employee retirement benefits. In fact, there is data from a number of surveys that suggest the majority of Americans would think twice about accepting a new position with a company that does not offer a retirement plan. The question is, what types of retirement plans are out there, and how many employees actually understand how they work? The simple answer is that there are essentially two types of retirement options employers offer, 401(k)s and Individual Retirement Accounts (IRAs), and learning what differentiates the two can be helpful in understanding how they both operate. 

​401(k)s
It would be safe to say that every American of working age has probably heard the term “401(k)” before, and not by coincidence. According to data analyzed by the US Census Bureau, nearly 80% of Americans work for a company that offers a 401(k), which is why the term has almost become synonymous with “retirement.”  Just because someone has heard the term though, doesn’t mean they know what it is. So, what exactly is a 401(k) you ask? The simplistic synopsis is that it is a special type of account that allows eligible employees of a company to save and invest for their own retirement through pre-tax payroll deductions. An employee can decide how much money they want deducted from their paycheck and deposited to the plan based on limits imposed by the plan and IRS rules. One key benefit is the plan participant can control how the funds in the account are invested between a number of different stocks, bonds, mutual funds, or other assets, and are not taxed on any capital gains, dividends, or interest until they are withdrawn. The employer may also choose to make contributions to the plan, often referred to as an employer match, but this is optional.

If someone faces a hardship and they need to access to their 401(k) funds before retirement, they’ll face a tax penalty. Individuals younger than 59 ½ years old are assessed an additional 10 percent penalty on top of the taxes imposed on the withdrawal. Short of a hardship withdraw, the IRS can only tax an employee for this money after he or she retires and begins withdrawing funds, which is subject to federal and state income taxes based on what the retiree’s tax bracket is at the time.
​
In addition to the tax advantages, employer match programs, and investment customization of 401(k)s, another benefit that makes them attractive is 401(k) loans. There may be times when an individual is strapped for cash and their only option is to prematurely tap in to their retirements savings. For that reason, the government allows plan administrators to offer 401(k) loans to participants. In most cases, the individual can borrow up to 50 percent of their vested account balance up to a maximum of $50,000 and must be paid back within 5 years (with the exception of home purchases, which are eligible for a longer time horizon). It should be noted that while 401(k) loans have become common place, the government does not require plans to offer them and therefore they are not always available. 

---

Individual Retirement Accounts (IRA)

Aside from 401(k)s, the other main vehicle for individuals to save for retirement are Individual Retirement Accounts, aka IRAs.  Similar to 401(k) plans, the funds contributed to an IRA are not taxable until you withdraw them. Fundamentally, there are two different types of IRAs, Traditional IRAs and Roth IRAs. A Traditional IRA involves taking money pre-tax, setting it aside in an account to grow tax-deferred, and then withdrawing it once the individual hits retirement age. Traditional IRAs are tax-deductible, meaning the participant can claim the contributions as a deduction on their income-tax return and the IRS will not apply income tax to those earnings. Roth IRA contributions are not tax-deductible, but qualified distributions are tax-free. For Roth IRAs, a person makes contributions with money they've already paid taxes on (after-tax), and their money may potentially grow tax-free, with tax-free withdrawals in retirement. In either case, employees can open these tax-advantaged accounts on their own through their bank or a broker and they are the sole owners of these accounts, hence the “individual” in IRA.
​
There are also what are called Simplified Employee Pension (SEP) IRAs and Savings Inventive Match Plan for Employees (SIMPLE) IRAs, which both adhere the same taxation rules for withdrawals as a traditional IRA. An SEP IRA is a retirement plan that small business or self-employed individual can set up for themselves or their company's employees and they can deduct the contributions from their reported business income and potentially secure a lower tax rate on that income. However, company employees are not allowed to contribute to their accounts, and the IRS taxes their withdrawals as income. SIMPLE IRAs are also intended for small business owners, but unlike SEP IRAs, employees are allowed to make contributions to their accounts, and the employer is required to contribute as well. 

​Key Differences
One primary distinction between a 401(k) and either a Traditional or Roth IRA is that former is an employer-based plan and latter is an individually owned plan. Another big distinction between the two is contribution limits imposed by the IRS. As of 2019, the max annual contribution limit of a 401(k) for someone under the age of 50 is $19,000. For anyone over the age of 50, an additional $6,000 can be contributed under the catch-up provision. The limit on annual contributions to an IRA in 2019 is $6,000, with a catch-up provision for individuals aged 50 and over set at $1,000 annually. Another distinct difference is the investment selection for each, with 401(k)s typically offering more limited investment selections that often offer pre-packed products such as target date funds, while IRAs usually have a vast selection of investments to choose from. All things considered though, it is commonly agreed upon that the best way for an individual to save for retirement is for them to work for an employer that has a 401(k) with an employer match and max out their annual contribution, as well as also maxing out a supplemental IRA account as a secondary retirement savings vessel.