Although a 401k plan seems similar to an Individual Retirement Arrangement (IRA), they are extremely different vehicles for your retirement savings. In general, a 401k is a retirement account offered by your employer and an IRA is an account that you may open for your personal retirement savings.
A 401k is a retirement plan that is tax-qualified under the Internal Revenue Code and sponsored by your employer. If your employer sponsors a 401k plan, you will have the choice to elect whether to have a portion of your compensation contributed to your 401k on a pre-tax basis. These wages that you defer are allowed to grow tax-free until you reach retirement age as it is defined under the plan. In the event you leave your employer prior to attaining normal retirement age, you will have the option to roll over the proceeds of your account to an IRA.
IRAs, on the other hand, are not tax-qualified plans. You have the option of opening an IRA as a means of saving additional money outside of any employer-sponsored plans. Your contributions to your IRA will be made after-tax and you have until April 15 each year to make additional contributions for the year prior. Depending on your income, you will be able to deduct some or all of your contributions to an IRA from your current year tax filing.
Both 401ks and IRAs allow you to save for your retirement. Contributions to either account offer certain tax advantages. Though 401ks and IRAs have different contribution limits, they both may feature catch-up contributions for individuals who have attained age 50 or older. It is not mandatory that your 401k offer catch-up contributions; it is simply a plan design option. Lastly, distributions are taxable from both 401ks and IRAs in the year in which you receive a distribution. There are penalties associated with early withdrawals from both types of retirement account.
Although contributions to both plans offer tax advantages, contributions to your 401k reduce your taxable income as these contributions are taken out of your salary on a pre-tax basis. Your contributions to an IRA are made on a post-tax basis.
In 2010, you may contribute up to $16,500 to your 401k plan whereas contributions to your IRA are limited to $5,000. The amounts of catch-up contributions are significantly different as well, with eligible individuals being able to contribute an additional $5,500 to a 401k and only $1,000 to an IRA.
Employers may match your contributions in a 401k if the plan is designed to do so. There is no match option for an IRA.
Comparing these two retirement savings accounts is a little like comparing apples to oranges, as one is an employee benefit and the other is an optional personal retirement savings account. If you have the ability to participate in a 401k, you certainly should take advantage of that, especially if your company matches any part of your contributions. If your company does not offer a 401k, you should consider opening an IRA so that you can save something for your retirement and possibly enjoy a tax deduction. Depending on your financial situation, you may consider contributing to both a 401k and an IRA. To determine the ideal retirement savings plan for you and your family, you should consult your personal tax professional.
Kay Lee began freelance writing for Answerbag and eHow in 2010. She is an attorney in Washington, DC, practicing since 2006. Lee specializes in employee benefits and executive compensation. She holds a Juris Doctor from the Columbus School of Law and a Master of Laws from Georgetown University Law Center.