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From a tax perspective, what is the difference between a 401K and an IRA account?

Mar 12, 2014 by william from Potomac, MD in  |  Flag
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8 votes

William they are both tax-deferred and therefore operate the same from a tax perspective. A 401(k) is tax-deferred from a payroll deduction while an IRA is tax-deferred from an annual contribution.

Comment   |  Flag   |  Mar 12, 2014 from Denver, CO

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6 votes

Hi William,

Another difference not yet mentioned has to do with when you can make penalty-free withdrawals from each type of account.

From an IRA, except for certain exceptions, you cannot make penalty-free withdrawals until age 59-1/2. The exceptions include incidents of death, disability, divorce, first-time home purchase or college expenses (up to $10k), and un-reimbursed medical expenses in excess of 10% of your Adjusted Gross Income. Withdrawals prior to 59-1/2 for reasons other than these incur a 10% tax penalty, in addition to any normal income taxes owed.

From a 401(k), if you have separated from service with the employer, whether it be retirement or termination, you can make penalty-free withdrawals as early as age 55. Also, sometimes 401(k)'s allow for a loan to be taken - this varies based on each individual plan. IRAs, on the other hand, do not allow loans.

Your question is broad and there are many, many facets of small rule differences, even though at the surface level both are vehicles for saving for retirement. One final difference that comes to mind that hasn't been mentioned is that with a 401(k), you may only invest in the plan's investment options. Some plans have very limited options; others have a broad menu of choices. IRAs, on the other hand, can be invested virtually however you want - it will be determined mostly by the custodian you choose to place the account with. For example, if you go to a bank, you may be given the option of an IRA invested in a CD, unless you talk with their 'investment people'. Mutual fund companies will use mutual funds, brokerage houses like Fidelity, Schwab, and others will allow you to use the broad universe of mutual funds, ETFs, stocks, bonds, CDs.

Good luck in your search to understand these plan type differences!

Michelle Ash http://www.wealthguards.com

Comment   |  Flag   |  Mar 13, 2014 from Jacksonville, FL

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Hey William. Off the top of my head, the main differences are - 401k Plans - You can only make contributions through payroll deductions. Often you'll receive matching employer contributions for some of what you contribute. 100% of your contributions are before tax so tax deductible. Maximum amount you can contribute is much higher than an IRA, currently $17,500 if you're under age 50 plus another $5,500 catch up contribution if you're age 50+. 401k plans can allow loans whereas IRA's don't. You can delay age 70 1/2 required distributions from a 401k plan if you're still working at the company it resides with. Plan investment options are limited to whatever your employer has chosen to make available to you. Creditor protection is a little stronger in most states for funds in a 401k vs. IRA.

IRA - maximum contribution is $5,500 if under age 50 plus $1,000 more if age 50+. May or may not be tax deductible depending on you and your spouse family income and access to employer based retirement plans. Required distributions begin at age 70 1/2. Very flexible on how and where you invest based on your own preference.

Comment   |  Flag   |  Mar 12, 2014 from Georgetown, TX

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There is one minor tax difference between a traditional IRA and traditional 401(k). Under current tax law you will be required to take required minimum distributions from the IRA beginning after age 70-1/2. But a non-owner employee who continues to work for the employer past the age of 70-1/2 will not be required to take the first distribution until the year after retirement.

Comment   |  Flag   |  Mar 13, 2014 from Woodbridge, VA

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First a few basics worth mentioning: assuming all pre-tax dollars contributed to either, withdrawals are taxed at ordinary income (see exception below), so realize you are converting capital gains to income which may mean higher, albeit delayed, tax rate after contribute enough to pick up max employer contribution in 401k, be sure to consider current marginal tax rate and expected tax rate during retirement, especially if eligible for Roth IRA * question assumes comparing 'Traditional' type for each; there are also Roth for each, though not all employers offer Roth 401ks; as mentioned there are income limits on Roth IRA though a strategy allows use if no or low existing IRA balances

A couple more nuances not mentioned yet: you need to be working through age 55 to take advantage of early withdrawals without penalty if you have company stock in a 401k that has appreciated, learn about Net Unrealized Appreciation which may allow capital gains tax rate on appreciation (complex rules, consult professional).

Comment   |  Flag   |  Mar 16, 2014 from Western Springs, IL

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Quick note just in case you're looking at attempting to do both - if you're covered by a 401k at work and you make above a certain IRS limit, you won't be able to deduct the IRA contributions. In that case, the 401k and its higher limits are more advantageous. See here for more info: http://www.irs.gov/Retirement-Plans/IRA-Deduction-Limits

Comment   |  Flag   |  Mar 27, 2014 from Alexandria, VA

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William, they both offer tax deferred savings that can be accessed penalty-free at age 59 ½, or in the case of a Roth account for either, tax free growth. In a 401(k), if you separate service from your employer, you can access money penalty-free at age 55. You can get certain hardship withdrawals penalty-free and possibly loans from a 401(k), depending on the actual plan.

You must take Required Minimum Distributions, or RMDs from either at age 70 ½, but if you are still working, you can still contribute and do not need to take RMDs from a 401(k)

Probably the main difference is that you can deduct up to $17,500 - $23,000 if over 50- into a 401(k) and you can only deduct $5500 - $6500 if over 50- into an IRA.

I hope this helps

Comment   |  Flag   |  Mar 25, 2014 from Delray Beach, FL

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