What Is the Difference Between an IRA and a 401(k)?

by Tim Plaehn

An individual retirement arrangement -- IRA -- and a 401(k) plan are both "qualified" retirement savings plans under the tax code. Qualified means the money deposited in a plan can reduce current taxable income and the assets in the plan can grow tax-deferred until withdrawals are made in your retirement years. The differences between 401(k)s and IRAs include who can set up the different types of qualified plans and how much money can be diverted from income into an IRA or 401(k) account.

IRA Means Individual

IRAs are set up by individuals, not by employers. To set up an IRA account, an individual selects a bank, insurance company, mutual fund company or brokerage firm to act as the custodian, but the individual determines the investments and how much money to deposit each year. An IRA account can be used for retirement savings by an individual who does not have an employer-sponsored retirement plan or as retirement savings in addition to what an employer offers. An individual must have earned income -- from wages or self-employment -- to make IRA contributions.

Limits and Deductions

At the time of publication, the maximum annual contribution limit into an IRA account is $5,000 -- $6,000 if you are over age 50. The same amount can be deposited for a non-working spouse. IRA contributions are fully tax-deductible if you are not covered by a retirement plan at work. If your employer provides access to a qualified retirement plan, the IRA contribution amount you can deduct may be reduced or eliminated, depending the level of your tax-adjusted gross income. At publication, IRA deduction limits when an employer plan is involved are reduced at incomes $58,000 for taxpayers filing singly and $92,000 if married filing jointly.

Employer-Sponsored 401(k)

A 401(k) plan is established by an employer to allow employees to make before-tax salary reduction contributions into a qualified retirement plan. The employer picks the plan administrator and selects the investment choices that will be offered in the plan and sets the participation and vesting rules for the 401(k). Besides the money employees may elect to defer into their 401k accounts, the employer may make contributions for employees. Employer contributions may be either a fixed percentage of wages, matching funds to employee contributions or profit-sharing based on overall company results.

401(k) Limits

At publication, an employee under age 50 can defer and contribute up to $17,000 annually -- or 100 percent of her salary, whichever is smaller -- to her 401(k) account . When over age 50, an employee is able to increase the maximum contribution by an additional $5,500. Including additional employer contributions, the maximum that can be contributed to an employee's account is $50,000 in a year. Each year, the Internal Revenue Service adjusts 401(k) contribution limits to account for inflation, so in future years your maximum contribution may be higher.

Considerations

If your employer offers a 401(k) plan, make sure you participate at a level to maximize the possible employer contributions -- this is like free extra retirement savings. An IRA account allows someone not covered by a retirement plan at work to still save for retirement on a tax-advantaged basis. IRAs also offer more control over the money in the account than 401(k) plans offer, since IRA funds can be invested in almost any type of security, while 401(k) investments are limited to the choices offered by an employer.

About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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