To clarify the difference between 401k and IRA plans, for the sake of this discussion we will be talking about standard 401k plans and the Traditional IRA. A 401k plan and a Traditional IRA (often called an individual retirement account) are similar in many ways; however, the most fundamental difference is that the 401k is set up by an employer or sole proprietor while an IRA is set up by an individual. For this article, much of the 401(k) information can be extrapolated to those with 403(b) plans, as there are many similarities when comparing against IRA plans.
Both 401k and traditional IRA retirement plans are considered pre-tax although with the IRA, contributions are actually considered to be deductible from your taxes, in essence making it a “pre-tax” investment. In both the 401k and traditional IRA your distributions are taxed as ordinary income once you decide to draw on it (hopefully after age 59 1/2). Like most retirement plans if you take distributions before age 59 1/2 you are penalized (you are also allowed to take distributions in some cases if you become disabled).
One major difference between plans is the amount you are allowed to contribute to each plan in a given tax year. In 2012, if you are under 50 years old you are allowed to contribute $17,000 to your employer’s 401k plan. You are allowed to contribute up to $49,000 if the remainder comes from your employer as an “annual addition” (403b contribution limits are comparable). With the Traditional IRA, you can only contribute $5,000 a year if you are less than 50 years old. Clearly, the 401k allows you to save more every year in pre-tax dollars than you can with a traditional IRA plan.
Most individuals would put money in a 401k first and then additional funds into an IRA. The biggest reason you would do this is because employers often offer some type of match for money you put into your 401(k). When it comes to flexibility of managing your money, some people argue that you have more flexibility with your money in a traditional IRA. This is because there are many brokerage firms online and offline that offer a wide variety of instruments for you to invest in. Many offer mutual funds, ETFs, stocks and even stock options for building complex investment strategies. With 401k plans you are at the mercy of your employer’s plan and what their financial vendor offers you. Sometimes you get a short list of mutual funds that you get to choose from and little else.
Fees also play a role in considering whether to invest your money in an IRA or a 401k first. It is easy to find an online brokerage firm these days that offers “no fee” IRA accounts with low minimum balances. As far as 401k plans go, they frequently get charged fees for investment services, administrative services, consulting services. Sometimes these fees are paid by the company and sometimes they are paid by the employees.
Again, many people take advantage of their company’s 401k plan because there is some type of match being offered. You can’t argue with free money. Keep in mind if you change jobs, whatever money you have accumulated in your 401k can be rolled into a traditional IRA with no impact to your taxable income. You can often times keep your existing 401k with your old employer if you change jobs, but you can roll it over to a traditional IRA or Roth IRA for the flexibility it offers.
The major difference between 401k and IRA plans, again, is that one is set up by your employer and one is set up by you. If you decide to contribute to your employer’s 401k plan or 403b plan, you can keep the IRA in your back pocket for when tax season rolls around. Did you underpay or not withhold enough taxes? Need to lose $5,000 in taxable income? Open a traditional IRA or Roth IRA account.