If you’re looking at retiring in the future, you’ve probably heard of an IRA and a 401(k). But what’s the difference between these two retirement-saving plans? The bottom-line answer: one is employer sponsored and one you can open with almost any provider.

Before you read any further, it’s important to know you can have both. There is no rule that says you can’t have an IRA and a 401(k). But knowing the differences between the two can help you decide the best way to reach your retirement goals.

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What Are the Different Retirement Plans?

In this article we will be talking about the differences among four main retirement accounts:

  1. Traditional IRA
  2. Roth IRA
  3. Traditional 401(k)
  4. Roth 401(k)

An IRA is an individual retirement account (or arrangement) to help save for retirement. And depending on which type of IRA you set up, you’ll get different tax benefits. There are two main types of IRAs: traditional and Roth.

Traditional IRA: A traditional IRA has pre-tax contributions which lowers your taxable income. Taxes are deferred until you start making withdrawals.

Roth IRA: A Roth IRA consists of post-tax contributions. This means your withdrawals are tax-free. However, there are certain restrictions with IRAs about who can have them and take withdrawals.

A 401(k) is an employer-sponsored retirement plan named after Section 401(k) in the Revenue Act of 1978. It allows employers to offer their employees tax-advantaged savings accounts. While a traditional 401(k) is the most common, some employers have started offering Roth 401(k) plans.

Traditional 401(k): A traditional account is like a traditional IRA. Contributions are pretax and lower your taxable income. You then pay taxes on your withdrawals in the future. If your employer offers contribution matching, a traditional 401(k) is the only plan it can contribute to.

Roth 401(k): A Roth 401(k) also has similar attributes to its IRA counterpart. The contributions are after taxes and have tax-free withdrawals. However, not all employers offer a Roth 401(k).

Who Is Eligible for an IRA or 401(k)?

Not everyone is eligible for an IRA, and not everyone is eligible for a 401(k). If you want to know whether you’re qualified for one of these retirement accounts, the requirements are described below.

Traditional IRA: You can open a traditional IRA if you received taxable compensation during the year and don’t turn 70 1/2 by the end of the year.

Roth IRA: There is no age restriction on a Roth IRA. Anyone can open one. However, there are restrictions on who can contribute and how much based on income and filing status. Check the IRS Roth contribution rules to see if you can contribute.

401(k) plan: Anyone can have a 401(k) through their employer since it’s an employer-sponsored account. According to the IRS, an employee must be allowed to participate in a 401(k) if the person is 21 years of age, has given one year of service, and works 1,000 hours in 12 months.

How Much Can I Contribute to an IRA or 401(k)?

Each account – IRA and 401(k) – has different contribution limits. However, 401(k) contribution limits were raised for all contributors. The amounts listed below are for 2022.

IRAs: The contribution limit per year for a person under the age of 50 is $6,000. Once you’ve reached 50, you get an additional $1,000 to “catch up” for retirement. That means you can contribute a total of up to $7,000 each year.

401(k)s: For an employee under the age of 50, the contribution limit is $20,500. This is considerably more than the IRA contribution limit. The “catch up” addition is also great at $6,500 per year. For a total contribution of $27,000 once you’re 50 years old.

Regardless of how many accounts you have, IRA or 401(k), the limit stays the same. For example, if you have two IRAs, you can contribute $4,000 to one and $2,000 to the other. Or you can contribute $6,000 entirely to one. This concept also applies to 401(k)s. While you can contribute to only a 401(k) plan with your current employer, some allow you to have both a traditional and a Roth 401(k).

Employer Contribution Matching

Employer contributions apply only to 401(k) plans. It’s one of the great benefits. In addition to employee contribution limits, your employer also has a contribution limit. It’s the lesser of…

  • 100% of employee compensation
  • $61,000 for an employee under 50 years of age
  • $67,500 for an employee over 50 years of age.

Every employer matches differently, so it’s important to understand your employer’s arrangement. However, this is free money. If you have a 401(k), try to take advantage of this opportunity.

How Do Distributions Work?

Some retirement plans have required minimum distributions (RMDs). This is a withdrawal from the account that you must make, and usually there’s a specific amount. This applies to traditional IRAs and both 401(k) plans. For IRAs, you must take the RMD when you turn 70 1/2. For 401(k)s, you take the RMD when you turn 70 1/2 or when you retire, whichever comes later.

Note that you can take distributions before reaching the age of 70 1/2. Once you turn 59 1/2, you can start to take withdrawals without a penalty fee. If you withdraw funds before reaching 59 1/2 years of age, there’s a 10% penalty fee.

Roth IRAs are a little bit different because there are no RMDs. Your withdrawals will be tax-free if you’re at least 59 1/2 year of age and it’s been at least five years since your first contribution. There are also qualified distributions that allow some exceptions to the rules. Check out the IRS Roth distribution rules to see if your distribution qualifies.

Both IRA and 401(k) plans are great retirement planning tools. Planning your finances for retirement doesn’t have to be hard. And there are simple steps you can take to make your life easier down the road.