There are many similarities between a 401(k) plan account and an individual retirement account (IRA). But there are also differences that can make them more difficult to understand. If you get these two retirement savings vehicles mixed up, or you really don't fully understand what either is, you're not alone. IRAs and 401(k) accounts are confusing to lots of Americans.
To get to the bottom of the basics, we can answer journalists' favorite questions: Who, what, when, where, why and how?
Who can participate?
--IRA: Anyone under the age of 70 1/2, earning an income can participate in an IRA. In addition, if you have a non-income-earning spouse and you file a joint tax return, you can make an IRA contribution for that spouse as long as your income is more than the contribution. IRAs do have income limitations when it comes to certain tax benefits, though. Some high-earning individuals and married couples won't be able to take advantage of all the tax benefits of an IRA.
--401(k): You must work for an employer who provides a 401(k) plan in order to have an account. Furthermore, 401(k) plans are a benefit, so your employer can place limitations on who can participate and when.
What are these accounts?
IRA and 401(k) accounts are two retirement vehicles that, along with a few others, have tax benefits designed to help Americans accumulate more money for retirement and to encourage us to save more.
--IRA: No one will automatically sign you up for an IRA account, and these accounts are not related to your employer. The account owner makes traditional IRA or Roth IRA contributions, and can select any combination of investments the platform allows. Traditional IRA contributions aren't payroll deductions, so they're not, technically, made pre-tax. Rather, income-eligible account owners may take tax deductions for traditional contributions. Roth IRA contributions aren't tax deductible.
--401(k): If you have access to a 401(k) account, it's through an employer-sponsored plan. Some employers have automatic enrollment and even automatic contribution increases. Contributions are made via payroll deduction; traditional contributions are made pre-tax and reduce your taxable income, and Roth contributions are made after-tax.
When the account owner reaches retirement age and begins taking distributions, money contributed to an IRA or 401(k) account on a traditional basis will be subject to ordinary income taxes. The amount of your tax liability will be dependent on whether contributions were made with pre-tax or after-tax money. Any money contributed to a Roth IRA will not be subject to additional taxes as long as certain requirements are met.
When do you take distributions?
The IRS allows account owners to begin taking penalty-free distributions from IRAs and 401(k) accounts at age 59 1/2. There are exceptions, so please consult with a tax adviser regarding your personal situation. With a 401(k) plan, the employer may place stricter guidelines on distributions while you are still working. The IRS requires distributions start by the April following the calendar year an account owner turns 70 1/2, and then occur every calendar year after age 70 1/2.
Where can you put your money?
--IRA: Financial institutions that offer IRAs often provide access to virtually any securities investment. Sometimes there are restrictions and limitations, so research several options for your IRA.
--401(k): Employer-sponsored plans, like a 401(k), offer a limited number of investments, usually an array of mutual funds from several asset classes and sectors. You may also have a brokerage option that would grant access to additional investment options, but that may come with extra fees or expenses within the 401(k) setting.
Why do contribution limits change?
IRA and 401(k) account contribution limits may increase or remain steady from one calendar year to the next. The IRS increases limits as needed for each plan in an effort to keep pace with inflation.
How much can you contribute?
--IRA: In 2013, most retirement savers can contribute up to $5,500 total to all IRAs, both Roth and traditional. If you're age 50 or older, you can catch up with an extra $1,000, so your maximum allowable contribution is $6,500. From the year you reach age 70 1/2 onward, you can't make traditional IRA contributions, but you can make Roth contributions. Your ability to take tax deductions on these contributions can be limited by your marital status, your income and whether you have access to a retirement plan at work.
--401(k): In 2013, most retirement savers can contribute $17,500 to a 401(k) account; people who are 50+ years of age can contribute an additional $5,500 for a total maximum of $23,000. Employers may also match a certain amount of your 401(k) contribution. Your employer's contribution limit is dependent upon your contribution: the total of all contributions made by you and your employer cannot exceed $51,000 or 100 percent of your income, whichever is less.
As always, consult a tax adviser during the process of deciding how much to contribute to or take out of a retirement account.
Scott Holsopple is the president of Smart401k, offering easy-to-use, cost-effective 401(k) advice and solutions for the everyday investor. His advice has been featured on various news outlets, including FOX Business, USA Today and The Wall Street Journal.
Nothing in this article should be construed as tax advice. Contact a qualified tax professional to discuss any tax matters relating to your retirement plan and investment option.