Are an IRA and 401k the Same? What You Need to Know…

Are an IRA and 401K the same thing – or are there differences between these types of retirement plans? They are definitely not the same thing – but they do share quite a few similarities, leading to people mistaking them for each other. But that’s not something you need to worry about any longer. Today, we’re going to look at the difference between 401ks vs IRAs.

Retirement involves a person making the decision to leave the workforce for good. Typically people do this due to old age but technically people can retire whenever (even though the retirement age is at least 59 years and 6 months old depending on what you are looking at).  When it comes time to retire, many people don’t have a retirement plan together. In fact, 41% of Americans say that it will take a miracle for them to be ready for retirement. However, that shouldn’t be the case!

There are plenty of possibilities available that can help people save for their retirement plans. These options can not only help people save, but can actually grow and help people get more money than what they put in! The two most common are the 401 k and IRA accounts. We’ll fully unpack both of these for you today – starting with the 401k.

What is a 401(k) Plan?

This is a type of employer-sponsored retirement account. If an employer can provide the option for a 401(k) plan then people typically choose this account because of tax benefits. There are also other benefits, as you’ll learn below.

On top of that, it’s easy to save for 401(k) plans because the contribution (the amount you deposit into the account) is automatically withdrawn. Once the funds are deposited into the account, then they can be invested toward different opportunities that the company provides.

When it comes to contributions for a 401(k),  it is important to keep in mind that the employer could match a portion or all of what you put in! However, you will face limits on how much you can put in. For example, in 2022 the contribution limits are:

  • $20,500 for people younger than 50 years old
  • $27,000 for people older than 50 years old

We encourage you to learn more about how 401K matching works in our blog. When it comes to 401(k) plans, there is more than one option to consider! There is a Traditional 401(k) and a Roth 401(k).

Traditional 401(k) Plan

When people think of a 401(k) this is what they often think of. Funds that the employee deposits are deducted from their gross income. What does that mean? Well since the money comes out of the employee’s paycheck before taxes are applied, that means the funds in the account are pre-tax.

Why is that important? That means that employees can consider these contributions as tax deductions. This can reduce the overall amount that an employee will be responsible for paying income taxes on. For example, if you would typically pay tax on $50,000 worth of income, but you deduct your $5,000 contribution then you would only need to pay taxes on $45,000.

There are some rules that come along with a 401(k) plan as well. For example, for a Traditional 401(k) you will need to take out required minimum distributions (RMDs) that must begin when the account holder is at least 72 years old. This means you will be required to take funds out even if you want to wait.

The biggest benefit to a Traditional 401(k) comes down to reducing taxable income in the present day. However, when it comes time to take out the money from a Traditional 401(k) you can expect to deal with taxes. The funds in the account will be taxed at the standard income tax rate. Your income tax rate will vary depending on the tax bracket you are in.

If you decide to take out the funds before you are supposed to then you may even find that you have to deal with penalties as well. Learn more about whether or not 401k contributions are subject to FICA in our blog.

Roth 401(k) Plan

Besides a Traditional 401(k) plan, there is a Roth 401(k) plan. This type of retirement account is funded with after-tax income. That means that instead of being able to see tax benefits right away (like with a deduction), these funds will see benefits a bit differently.

You will not be able to consider the deposits you make as deductions. However, even though you don’t get tax benefits right away, you will see the benefits down the line when it’s time to take out money. The money you withdraw must be qualifying. That means meeting requirements like:

  • It’s been 5 years since the account holder opened and deposited funds into their account
  • The account holder is at least 59 years and 6 months old at the time of withdrawal

What is an Individual Retirement Account (IRA)?

Besides a 401(k) plan, another type of retirement account is an IRA. There are two popular types of IRAs:

  • Traditional IRA
  • Roth IRA

Each option can benefit individuals differently depending on the type of account. However, both of them have contribution limits just like a 401(k). For 2021 and 2022 the contribution limits for a Traditional IRA and Roth IRA are:

  • $6,000 for individuals younger than 50 years old
  • $7,000 for individuals older than 50 years old

Traditional IRA

A traditional IRA works like a traditional 401(k). This type of account allows people to put pre-tax income towards investments like mutual funds, stocks, etc. As these investments grow in the account, they are tax-deferred (until withdrawals occur).

Individuals can start taking out penalty-free funds once they are 59 years and 6 months old (59 ½).  Typically, traditional IRA contributions are tax-deductible. That means you can see tax benefits immediately by paying taxes on a reduced income after the tax deduction is applied.

Traditional IRA distributions (also known as withdrawals) will be seen as taxable income once you take them out. That means they will be taxed at the standard income tax rate at your income level.

There are penalties that an account holder may face if they try to withdraw the funds too early. The penalty can be worth up to 10% of the amount withdrawn. Here are a few cases where you may be exempt from penalties:

  • The funds go towards rebuilding or buying a first home for the account holder or qualifying family member (this has a lifetime limit of $10,000)
  • The account holder becomes disabled and the beneficiary receives assets
  • The account holder dies and the beneficiary receives assets
  • Assets go towards unreimbursed medical expenses
  • Distributions that go towards the Substantially Equal Periodic Payment (SEPP) program
  • The assets go towards the cost have having or adopting a child (with a $5,000 limit)
  • Assets that go towards handling the cost of medical insurance if they the account holder is  unemployed
  • Distributions that are a part of an Internal Revenue Service (IRS) levy
  • The account holder is a part of the military and is called to active duty for at least 179 days

Roth IRA

A Roth IRA is an account that allows people to put after-tax funds towards investments. These investments (like mutual funds, stocks, etc.) can grow tax-free!

Just like the other retirement accounts on this list, a Roth IRA comes along with tax benefits! Even though contributions for a Roth IRA cannot be counted as a tax deduction, the benefit appears later on down the line.

Once withdrawals occur, these accounts will be tax-free as long as it is a qualifying distribution. This is a popular account option for people saving for retirement because it doesn’t have rules like a required minimum distribution (RMD).

So, Are an IRA and 401K the Same Thing?

So – with all that said, are an IRA and 401K the same thing? We’ve talked a lot about both of these retirement savings accounts. And you can now see that they share some similarities, but are actually quite different. It all comes down to the tax advantages each offer.

While these accounts are similar since they are all designed to help for retirement, they are not the same. Each option is unique even if it shares common traits like contribution limits, penalties, exceptions, RMDs, etc.

Now that you learned about these different account options for retirement, you will want to compare them. Many people have a mix of these accounts while others only have one. Even though these accounts have similar names, they are different accounts. That means each option will have its own set of rules, limits, etc.

You need to keep in mind that not anyone can get a 401(k) since this type of account is only offered by employers. That is why you will want to first see if you even have the option to have this type of account.

IRA vs 401K: Which is Best for Me?

When comparing your options you want to look at the pros and cons of each. This can help you look at the good and bad that comes along with the account. We are going to sound like a broken record but we truly just want the best for you.

That is why you will need to talk to a professional that can help you handle these accounts and plan for retirement. Professionals will be able to provide you with expert advice based on what you’re dealing with.

Pros and Cons of IRAs

  • There are a variety of investment options
  • It’s easy to set up these accounts
  • A Roth IRA allows penalty-free withdrawals
  • A Roth IRA can be good for estate planning

On the other hand, there are some drawbacks that come along with this option. Some of the cons that come along with this type of account include:

  • Low contribution limits
  • Can be hard to find investment advice

Pros and Cons of 401Ks

Now that you know about the pros and cons of IRAs, let’s take a look at the pros and cons that come along with a 401(k) plan! Some benefits of a 401(k) plan includes:

  • High contribution limits
  • Potentially free money thanks to company matches (if available)
  • There is no income limit when contributing with pre-tax income
  • There may be free investment advice that a plan administrator provides

While these accounts have some nice benefits, there are some drawbacks that you will want to keep in mind. Some cons of these accounts include:

  • Limited opportunities since it is only offered by employers
  • Lack of options when it comes to picking an investment

So – are 401k accounts worth it? Only you can answer that question for yourself! However, we do hope this breakdown helps.

Final Thoughts on the IRA vs 401K Debate

There you have it – everything you need to know about the IRa vs 401K debate. We answered the main question you came here with: are an IRa and 401K the same thing? As you now know, these retirement savings accounts are quite similar – but offer varying tax advantages. There are also differences in the annual contribution limit, along with penalties.

When it comes to getting a retirement plan together, there are two popular types of accounts that people use. There are 401(k) plans and IRAs. Even though these accounts are similar, they are in fact different. The best way to find what option is best for you involves speaking to a professional. However, besides speaking to a professional, you can compare the pros and cons of each option.

Want to learn more about retirement savings accounts? Our blog has awesome resources for you – including what to do with 401K when switching jobs, 401k for self-employed individuals, how 401K loans work, and more.

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