The Differences in an IRA, Roth IRA and 401k
Three qualified retirement plan options recognized by the Internal Revenue Service include traditional Individual Retirement Accounts, Roth IRAs and 401k plans. You create and manage your IRA independently of your employer, while 401k plans can only be contributed to if your employer offers such a plan. Knowing the differences in these plans can help you maximize your retirement savings.
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Tax Treatment
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The tax treatment of the different accounts makes a big difference as to which type of plan you benefit most from. Traditional IRAs and 401k plans offer tax-deferred savings, which means your contributions reduce your taxable income when you make them, but you have to pay taxes on your distributions. Roth IRAs function in an opposite manner; your qualified withdrawals do not count as income, but your contributions do not reduce your tax liabilities. People who expect to pay a higher income tax rate at retirement typically benefit from the after-tax savings of a Roth IRA, while people expecting to be in a lower income tax bracket at retirement tend to benefit from tax-deferred accounts.
Investment Options
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You must set up a traditional IRA or a Roth IRA on your own, but this gives you more flexibility in deciding which financial institution you want to use and how you want to invest your money. Conversely, employers set up 401k plans on behalf of their employees and set up the investment options for the plan. This can be beneficial if the company can negotiate fees and they offer investments that interest you. However, you are limited to those investments.
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Contribution Limitations
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The IRS sets different contribution limits for IRAs than it does for 401k plans, and these plans change over time to reflect changes in the cost of living. The total contribution limit for both traditional IRAs and Roth IRAs equals $5,000 as of 2011, and employers cannot contribute. The contribution limits for 401k plans are more generous, up to $16,500 for individuals and a total of no more than $49,000 of individual plus employer contributions for 2011.
Early Distributions
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IRAs allow you to remove the money at any time, but impose a 10 percent early withdrawal penalty on the taxable portion of the distribution. Roth IRA contributions can be withdrawn penalty-free and tax-free, but Roth IRA earnings and all traditional IRA withdrawals are subject to taxes and penalties. Exceptions to the penalty for IRAs include up to $10,000 for costs of buying a first home, medical expenses over 7.5 percent of your adjusted gross income and college costs.
You can only take an early distribution from your 401k plan when you leave your job or have a severe financial hardship. However, the IRS makes no waiver of the 10 percent early withdrawal penalty from 401k plans for first-time home purchases or college costs. On the other hand, the IRS does allow you to borrow money from your 401k plan, which it expressly prohibits with IRAs.
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