Comparison of a 401(k) & an IRA
To encourage people to save money for retirement, the Internal Revenue Service offers retirement savings plans that provide a tax savings, including 401(k) plans and individual retirement accounts. Both types of plans offer a traditional option, in which contributions are not subject to income taxes but withdrawals are, and a Roth option, in which contributions do not receive any special tax breaks but you can withdraw the money tax-free at retirement. However, the two plans have important differences.
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Eligibility
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If you have earned income, you can open and contribute money towards an IRA. Your IRA is set up independently of your job. With an IRA, you must make the deposits after you have been paid, and your employer cannot contribute money to the account on your behalf. With a 401(k) plan, you can contribute only if you are employed by a company that offers 401(k) plans to its employees. The contributions that you make to a 401(k) plan are taken out of your paycheck, so you do not receive the money. 401(k) plans allow employers to make contributions to the account on behalf of the employee.
Features
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The investment options offered by a 401(k) depend on how many account options the company offers. Each company can offer many or few investment options for plan participants. Larger companies often provide more options because they can handle the additional expense. With an IRA, you have complete control over how you invest the money and which company you invest it with.
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Contribution Limits
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Both 401(k) plans and IRAs have annual contribution limits that restrict the amount of money you can contribute to each plan. This limits may adjust each year as dictated by inflation, and the 401(k) contribution limit is always larger than the IRA limit. For example, as of 2010, the annual limit for 401(k) contributions is $16,500 and the limit for IRAs is $5,000. If you are 50 or older, the IRS increases the contribution limit for 401(k) plans to $22,000 and for IRAs to $6,000.
Withdrawing Money
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In order to withdraw money penalty-free from your IRA, you must be at least 59 1/2 years old. However, you can take money out of your IRA at any time, but you may have to pay a 10 percent early withdrawal penalty unless you have a qualified exception such as first-time home buyer expenses, high medical costs or qualified college expenses. You can withdraw money from your 401(k) plan at the same age, or if you retire after age 55 you can start taking money out immediately. However, you can take money out of your 401(k) plan early only if you have a major financial need that you cannot satisfy with other funds, and you must pay a 10 percent penalty.
Loans
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An advantage of 401(k) plans over IRAs is that participants may be able to take out loans from the account. The IRS permits people to withdraw the lesser of 50 percent of the value of the account or $50,000 (as of 2010) from their 401(k) and repay it over five years with interest. If the loan is not repaid, the IRS will treat the money as a nonqualified distribution and you will have to pay taxes and penalties. The IRS does not permit you to take a loan from your IRA or use it as collateral.
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References
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