How Does an IRA Differ From a 401k?
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An IRA (Individual Retirement Account) is a personal retirement savings account that can be opened by any person who has received taxable income during the year. An IRA uses the power of both compound interest and tax deferment to grow any money you put aside for retirement. There are several regulations and guidelines that govern how much each person can put away each year in an IRA and when and under what circumstances those funds can be withdrawn.
A 401k (403b) for non-profits) on the other hand is an employer-sponsored retirement plan. The 401k plan also has the advantages of compounding and tax deferment but with higher contribution limits. Also some employers match the contributions their employees make.
401k - Employer Sponsored
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Many companies offer 401k plans as part of the benefits package for their employees. Many of these companies also match employees' retirement contributions up to a certain amount. It is therefore advisable that people take advantage of this. It is free money. The contribution limits are $15,000 in 2006 with a $500 increment each year to account for inflation when necessary, and an addition $5000 for people 50 years and over with the same increments to account for inflation.
After contributing the maximum amount matched by your employer it is a good idea to stick whatever is left of your allotment for retirement savings in a Roth IRA because of its peculiar tax advantages. See a link in resources below on how to plan where to put the money you have set aside for retirement.
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IRA - Individual Focused
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While the 401k cannot exist without employers, the IRA cannot exist without the individual. The money put aside in an IRA can be invested in the stock market, money market or certificates of deposits.
There are 11 types of IRAs but the two most common types are the traditional IRA and the Roth IRA. The traditional IRA can be opened by anyone with taxable income and an individual can contribute up to 100% of taxable income or $5000 ($6000 for those age 50 and over) in 2008, whichever is less. The contribution is tax deductible and therefore in effect is done with pretax dollars. Withdrawals are subject to income tax. A10% penalty applies with certain exceptions if the withdrawal is made before a person turns age 59 1/2. After age 70 1/2 mandatory withdrawals have to be made and if not, the IRA will be subject to a 50% excise tax.
With the Roth IRA, contributions are made with after-tax dollars and the individual contribution limit is the same as in a traditional IRA. Since contributions made are not tax-deductible, withdrawals (including initial contributions and earnings) are not subject to income tax, in other words, tax exempt in the long run. Withdrawals made after the individual is 59 1/2 years old or considered a qualified withdrawal are not subject to the 10% penalty. Other qualified withdrawals are those made: to a beneficiary after the taxpayer's death; because the taxpayer is disabled; by a first-time home buyer to buy a personal house.
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