What a 401(k) and an IRA are
The 401(k) and the IRA are the two main US retirement accounts. Here is how each one works, and the difference between traditional and Roth.
The 401(k) and the IRA are the two most common retirement accounts in the US. Both let investments grow without yearly tax on the gains. The main differences are who offers the account and how much you can put in.
The 401(k)
A 401(k) is a retirement plan offered by an employer. The name comes from the section of the US tax code that created it.
- How money goes in. You choose a share of each paycheck to contribute. It is taken out automatically before you get paid.
- Employer match. Many employers add money too, often matching part of what you put in. A match is extra pay that only arrives if you contribute.
- Investment choices. The plan offers a set menu, often a mix of stock funds, bond funds and target-date funds. A target-date fund shifts its mix from stocks toward bonds as a chosen retirement year gets closer.
- Vesting. Your own contributions are always yours. Employer contributions may vest, meaning become fully yours, over a period of years.
Similar plans exist for other employers. A 403(b) is common at schools and non-profits. A 457 plan is common in state and local government.
The IRA
IRA stands for individual retirement account. You open it yourself, at a bank or brokerage, without an employer.
- Who can contribute. Generally anyone with earned income, such as wages or self-employment income.
- Investment choices. Usually much wider than a 401(k). You can often hold individual stocks, bonds, ETFs and mutual funds.
- Contribution limits. IRA limits are much lower than 401(k) limits.
You can have both a 401(k) and an IRA at the same time.
Traditional vs Roth
Both the 401(k) and the IRA come in two tax styles. Not every employer offers both for its 401(k).
Traditional
- Going in: contributions are made before tax, or are tax-deductible, which can lower your tax bill this year.
- Growing: gains are not taxed while they stay in the account.
- Coming out: withdrawals in retirement are taxed as regular income.
Roth
- Going in: contributions are made with money you have already paid tax on. There is no deduction.
- Growing: gains are not taxed.
- Coming out: qualified withdrawals in retirement are tax-free.
The simple way to compare them: traditional gives you the tax break now; Roth gives you the tax break later. The choice often depends on whether you expect your tax rate to be higher or lower in retirement. Canadian readers may notice this is similar to the RRSP and TFSA.
Limits and eligibility
The IRS sets yearly contribution limits for each account. They are usually adjusted every year, and there are extra "catch-up" amounts for people over a certain age.
Some rules depend on income:
- Roth IRA contributions are limited or not allowed above certain income levels.
- The tax deduction for a traditional IRA can be reduced if you or your spouse are covered by a workplace plan and your income is above certain levels.
Check the current figures on the IRS website or with your plan provider.
Taking money out
These accounts are meant for retirement, so early withdrawals are discouraged.
- Withdrawals before age 59 and a half are generally taxed and also face a 10% penalty, though there are exceptions for certain situations.
- Traditional accounts require you to start taking minimum withdrawals once you reach an age set by law. These are called required minimum distributions, or RMDs.
- Roth IRAs do not require withdrawals during the original owner's lifetime.
Some 401(k) plans allow loans against your balance. Rules vary by plan.
When you change jobs
You can usually leave your money in your old employer's 401(k), move it to your new employer's plan, or move it into an IRA. Moving money between retirement accounts without paying tax is called a rollover. Cashing out instead can trigger tax and penalties.
Why these accounts matter for investing
Because gains are sheltered from yearly tax, more of your money stays invested and can grow. See how compound growth works.
Contributing a set amount from each paycheck is also a form of dollar-cost averaging.
For a choice that fits your own situation, a fee-only financial planner or tax professional can help.
The short version
- A 401(k) is offered by an employer; an IRA is one you open yourself.
- Many employers match part of 401(k) contributions.
- Traditional accounts give a tax break now; Roth accounts give it later.
- Yearly limits are set by the IRS and usually change each year.
- Early withdrawals before 59 and a half generally face tax and a penalty.
This is general information, not investment advice.
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