Which is Better, a 401k or an IRA?

••• Image by Flickr.com, courtesy of Alan Cleaver

You probably know that depending solely on Social Security for your retirement income is a poor choice. Establishing your own retirement savings, either through a 401k plan or an IRA, is more important than ever, but which one is better?

Differences and Similarities

A 401k is an employer-sponsored retirement plan. An individual retirement account (IRA) is an account you set up for yourself. Both offer immediate tax benefits and you can direct how the money is invested in each depending on your risk tolerance.

Contribution Limits

Tax laws limit how much money you can contribute into either type of account. The maximum limit for 401k contributions is usually much higher than the limit for an IRA. Maximum contributions to a 401k for 2009 and 2010 are $16,500, unless your employer’s plan has a percentage cap that could reduce the amount. The maximum contribution to an IRA is $5,000 as of 2009. If you’re older than 50, that increases to $6,000.

Matching Contributions

Some employers make partial matches to your 401k plan--typically 50 percent of your contributions for up to 6 percent of your salary. This is effectively free money, and a huge benefit. However, there are limits on when you can access these funds.

Tax Deduction

Both 401k plans and IRAs are tax-deductible until you withdraw the money. For a 401k plan, your employer will subtract your contributions before calculating income tax on your pay. In an IRA, you subtract your contributions for the year on your annual tax return.

Investment Options

While you can select how your want your retirement contributions invested, most 401k plans have preset structures that you must use, and they limit when you can make changes. You have many more choices when directing how your IRA is invested.