Although both 401a accounts and IRAs are types of retirement accounts, there are a variety of differences between them. Who is allowed to contribute, how and when you are taxed and rules for withdrawals are just a few of the considerations you must make when deciding when and how to use these accounts.
Workplace 401a accounts are defined contribution plans sponsored by employers that allow employees to save money for retirement while receiving tax benefits. The employer, the employee or both can contribute to the plan. An IRA, or individual retirement account, is not offered by an employer. But anyone under the age of 70 1/2 with taxable income can sign up for one. In order to contribute to a Roth IRA, participants must make $105,000 or less if filing taxes single or $167,000 if filing taxes jointly. Money in a 401a is invested in stocks, mutual funds, bonds or other investments. It also has many tax benefits. It is entirely possible to have both of these accounts.
With a 401a, employees can contribute up to 25 percent of their paychecks after taxes. Employers can contribute a percentage of the employee's contributions, match the employee's contribution or contribute a fixed amount during each pay period. Contributions to the account continue until the employee ceases employment with the organization or retires. Individuals contribute to an IRA; individuals under 50 years old can contribute up to $5,000 yearly as of 2010. If you're over 50, you can contribute $6,000.
For both types of IRAs as well as 401a accounts, funds are not taxed while they are in the account. When those with 401a accounts and traditional IRAs withdraw money, they are taxed on the amount they take out. Participants in a 401a plan can withdraw funds from their accounts when they discontinue employment with an organization, when they retire or withdraw funds as a loan if their particular plan permits it. Once an employee with a 401a leaves a company or retires, he may roll over the account into a new employer's account or into another retirement account. But if the account is cashed out before the plan's designated retirement age, typically 59 1/2, the withdrawal will be subject to a 10 percent penalty, plus regular income taxes owed. Early withdrawals from traditional IRAs face the same penalties and tax treatment. When IRA participants reach age 70 1/2, they must begin withdrawing the funds in a traditional IRA; Roth IRA participants may continue to pay into the IRA. With a traditional IRA, you pay taxes on withdrawals; with a Roth IRA, you pay taxes on contributions.
A 401a account can help reduce your income taxes as you save for retirement. Contributions are not included in your annual income, so your total tax is reduced. Earnings on your account increase and are not taxed until after you withdraw the funds. In some states, distributions are even exempt from state taxes. If your employer contributes to your 401a you will make even more for retirement than you would with a non-employer sponsored plan. IRA benefits are similar, in that you will only be taxed once on your contribution unless you take it out early. While your contributions are still included in your total income on your taxes, you can frequently deduct IRA contributions, which offers lowered taxes. The amount you can contribute to an IRA is typically less than you can contribute to a 401a. But an IRA typically offers more options for the type of investments you'd like to include, such as stocks, bonds and mutual funds.
Megan Martin has more than 10 years of experience writing for trade publications and corporate newsletters as well as literary journals. She holds a Bachelor of Arts from the University of Iowa and a Master of Fine Arts in writing from The School of the Art Institute of Chicago.