IRA vs. 401K - What's the Difference?

By Cristina Adams on Thursday October 15, 2009


Thinking of saving money for your golden years? Good thinking. You’re never too young to start stuffing the coffers. Two popular retirement investment vehicles are the 401K and the traditional IRA (individual retirement account). Simply put, a 401K is a retirement savings plan offered through your employer. An IRA is something you set up yourself with help from your bank or your mutual fund.

To 401K or not?
If your company offers a 401K, contribute to it, especially if your employer matches what you put in. Some companies match up to $0.50 for every dollar you put in, for up to 6% of your salary. It’s free money! Don't turn it down. Your own contributions to the plan are taken from your paycheck on a pre-tax basis, which can means more money for you. Eventually, Uncle Sam gets his due, but that’s only when you start withdrawing funds from your 401K, after the years of the interest in your plan growing tax-free. When you do start tapping into the money, you pay income taxes – at your current income tax rate. Think you’ll be pulling in a power salary as a retiree? Probably not. So don’t touch the 401K until you retire and are in a considerably lower income-tax bracket. That said, if you have to borrow from your 401K (say you have a medical emergency), you can. And as long as you pay it all back, there’s no fine, no nasty letter and no robo-calls.

Of course there are a few strings attached, including how much you can sock away every year. For 2009, the limit is $16,500 if you’re 49 or younger, and $22,000 if you’re 50 or older. For 2010, contributions limits will be indexed to inflation. There are rules for getting your hands on the money, too. Touch it before you turn 59 ½, and you’ll be slapped with a penalty if you don't pay it back. Likewise, you need to begin withdrawing before you’re 70 ½. The only caveat with 401Ks is this: Find out what your contributions are being invested in. Even if your investment choices are limited, you should know what they are and be ready to make changes when and where you can. Why? It’s not uncommon for a company to invest a sizable chunk of its 401K plan in its own stock. Then what happens if the company goes down in flames? Think Enron. No pension. No savings. No retirement.

The skinny on IRAs
An Individual Retirement Account, or IRA, is a way for you to save money for retirement that has nothing to do with an employer-sponsored 401K. You set up your own IRA (with a little help from your bank or financial planner) and deposit money into it every year. While you don’t get any matching contributions with an IRA, you usually have more investment choices – things like stocks, bonds, mutual funds and Certificates of Deposit (CDs). If you track your investments and don’t like how they’re performing, you can rearrange them, move more into CDs or bonds or whatever you prefer.

As with a 401K, the amount you contribute to your IRA is deducted from your taxable income, and you don’t pay the piper until you start making withdrawals. Unlike a 401K, however, you can’t borrow from an IRA. (There is a complicated thing you can do, which means opening a new account so you can move money from your IRA to the new account – and then you only have 60 days before you have to re-deposit the money back into the IRA. Unless you have several IRA accounts with plenty of money in each, this rigmarole isn’t worth it.)

Like 401Ks, IRAs impose contribution limits, although they’re much lower. For 2009, if you’re 49 or younger, you’re limited to $5,000; if you’re over 50, you can contribute up to $6,000. For 2010, contribution limits will rise in increments of $500 and will be indexed to inflation. One nice perk about putting money in your IRA: You can do it until tax filing day of the following calendar year. In other words, you have until, April 15, 2010 to sock it away.

The rollover option
Remember Roth IRAs? (DailyWorth featured news about the 2010 conversion option here) Contributions to a Roth IRA are not tax-deductible (you pay taxes on it up-front), but withdrawals are totally tax-free. That’s right. No taxes on earnings. Period. And a Roth IRA isn’t bogged down by as many rules as a traditional IRA. In fact, you may want to roll your IRA into a Roth IRA. If you're thinking about doing it this year, be sure you qualify. For 2009, you can roll your IRA into a Roth IRA if you’re single or filing jointly with your spouse, and your modified adjusted gross income (MAGI) is $100,000 or less. But the rules are changing. As of January 1, 2010, those limits are gone; anyone who has an IRA can convert it to a Roth IRA. If you do convert to a Roth IRA next year, you won’t be taxed for it in 2010. Instead, you can spread the tax hit out over two years, paying half in 2011 and half in 2012. That’s how badly Congress wants your money.

These are just a few of the fundamental ways in which most people save money for retirement these days. The bottom line is: If you have the luxury of an employer-sponsored 401K and opening your own IRA on the side, do both. Whenever you can, stash the cash.