Are IRA and 401k the Same?

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 plan. These options can not only help people save, but can actually grow and help people get more money than what they put in! Two opportunities that people consider are:

  • 401(k) Plans
  • Individual Retirement Accounts (IRAs)

What is a 401(k) Plan?

When it comes to retirement accounts, a 401(k) plan is a popular option! However, not everyone can benefit from this opportunity. That’s because employers are the ones that offer 401(k) plans. 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 that may come along with this type of account.

On top of that, it’s also easy to save for 401(k) plans because the contribution (the amount you deposit into the account) is automatically withdrawn.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 their account, then they can be invested towards 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. Just like other retirement accounts, there are contribution limits that people need to be aware of. For example in 2021 the contributions limits for a 401(k) were:

  • $19,500 for people younger than 50 years old
  • $26,000 for people older than 50 years old

It’s also important to note that contribution limits for 401(k) plans can change every year! 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

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 a tax deduction. Tax deductions 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. It’s important that you keep these rules in mind because they can impact how you handle your 401(k) plan. 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!

Taxes for a Traditional 401(k) 

The biggest benefit to a Traditional 401(k) comes down to the taxes which is why we want to explain these a little bit more in-depth. We may repeat ourselves but we just want to make sure you have a clear understanding of these two retirement accounts! When it comes to taxes, the funds that you put in are pre-tax. That means that your gross salary could see an impact. How could it see an impact? Well let’s say you deposit $3,000 into your 401(k) plan. You can write that deposit off as a tax deduction and would reduce your taxable gross income. When your taxable gross income is reduced then you will have a smaller tax obligation!

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. It is important to keep in mind that there are some exceptions to these taxes. For example, if you were born before 1936 and take your distribution (withdrawal) as a lump sum then that would be an exception.

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. That’s because once withdrawals occur, there will be no additional taxes that an employee needs to deal with. There are some rules that come along with this type of account as well. It’s important that you keep these rules in mind because they can impact how you handle your account. For example, for a Roth 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!

Taxes for a Roth 401(k) 

Just like with the Traditional 401(k), we think it’s important to talk about the tax side of things when it comes to a Roth 401(k) plan. It’s especially important because taxes are different for these accounts compared to the traditional option. These accounts are funded with after-tax dollars. That means 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

Regardless of whether it is a Traditional or 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

Luckily 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.

Keep in Mind…

There are rules to these accounts that people should keep in mind. 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. That rate is determined by your tax bracket which depends on your income level. Another rule would be the fact that you would need to take out required minimum distributions (RMDs) once you are at least 72 years old. This means you will be required to take funds out even if you want to wait!

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. However, there are exceptions when it comes to penalties! Some exceptions include:

  • Times where 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

The best way to see if you will have to deal with penalties and what taxes you will need to deal with is by talking to a professional. A professional could be a tax attorney, or even the IRS! However, an article online can’t give you a specific answer!

Roth IRA

Now that you better understand what a Traditional IRA is, let’s take a look at what a Roth IRA is! 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 opportunities 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).

401(k) vs IRA: What’s the Difference?

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.

How to Choose the Best Option?

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 come 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 planning for retirement. Professionals will be able to provide you expert advice based on what you’re dealing with. Let’s start off with IRAs. Some benefits of an IRA include:

  • 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 includes:

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

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 not an 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 includes:

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

Frequently Asked Questions

It can be complex when learning about different accounts you can use to save for retirement. That is why there are frequently asked questions that many people have when it comes to these types of accounts.

Are IRA and 401(k) the Same Type of Accounts?

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.

Why is Taxable Income Important When it Comes to a Traditional 401(k) and Traditional IRA?

Taxable income is relevant to these types of accounts in a couple different ways. For example, the contributions you make on these types of accounts reduces how much income you will pay taxes on. That’s because generally these contributions can be seen as a tax deduction since they are made with pre-tax income.

Taxable income is also relevant when it comes time to withdraw the funds in these accounts. That’s because the IRS will treat the withdrawals as taxable income. That is why they are subject to the standard income tax rate.

When Will an Employer Match Your 401(k) Contributions?

If you want to know when you can expect an employer match, you may be disappointed. That’s because it varies depending on the company. The best place to see if your employer will match your contributions is with your Human Resources (HR) department.

Bottom Line

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.

Let’s start off with IRAs. Some benefits of an IRA include:

  • 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 includes:

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

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 not an 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 includes:

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

Article References

https://www.thebalance.com/what-is-retirement-2388822

https://money.usnews.com/money/retirement/aging/articles/10-important-ages-for-retirement-planning

https://www.cnbc.com/2021/09/14/36percent-of-americans-say-they-wont-have-enough-to-retire-report-finds.html

https://www.investopedia.com/terms/1/401kplan.asp

https://www.investopedia.com/terms/i/ira.asp#toc-what-are-the-different-types-of-iras-and-their-rules

https://www.bankrate.com/retirement/ira-vs-401k/

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