A 401k and an IRA are both tax-advantaged accounts that incentivize saving/investing for retirement. They both restrict withdrawals from the account in exchange for deferring or excluding taxes.

The quick rundown of the differences are the following: you have more flexibility investing in an IRA, you have a higher contribution limit for a 401k, and your employer potentially matches contributions in your 401k (basically gives you free money in the account). But let’s go into some more detail.

401k

A 401k plan is an employer sponsored retirement plan. Not all employers offer one, but many large companies do. Most offer only a Traditional 401k, but there are some companies with Roth 401k options. The employer chooses which type of account to offer and has it set up with a plan manager. There are usually specific funds available for you to invest in within the account. You usually just fill out a form to assign how much of your paycheck you would like to put into the account and how to divide it up into the different options.

There are some restrictions on withdrawing the money put into this account but you get tax benefits in return. These restrictions and benefits depend on with type of contribution you make (Traditional vs Roth). The annual contribution limit is fairly high (in 2015 it is $18,000 if you are under 50 years old, $24,000 if you are over 50).

The big advantage to contributing to your 401k is employer matching. Your employer may match your contribution which means as you put money into the 401k, your employer will also give you money to put into the account.

For example, if your company has 100% matching up to 4% of your income and you make 100k annual salary, you can contribute 4k and your company will put in 4k. This effectively makes your annual salary 104k with 8k being paid to you through your 401k. If the company’s matching was only 50%, they will put in 2k when you put in your 4k in the example above. However, the company matched amount usually vests over some period of time which means if you leave the company, you only get the amount you are vested in. For example, if your company has a vesting schedule of 4 years evenly distributed, then in the first example above with 100% matching, you would get claim to an additional 1k each year.

You are also always 100% vested in your own contributions. So let’s take that example and say you don’t contribute anymore after the first year. If you leave after 3 years with the company, you would be entitled to 3k of the 4k match from your first year as well as your own 4k contribution plus whatever gains that 7k earned in the account.

Individual Retirement Account (IRA)

An IRA is an individual retirement account, meaning you will have to set it up yourself. You will need to reach out to a broker (Charles Schwab, Fidelity, TD Ameritrade, etc.) to set up an account and you decide whether you want to open a Traditional or Roth type. You manually move money into the account which has a smaller annual contribution limit ($6,000 in 2021, $7,000 if you are over 50) relative to the 401k.

You get the same restrictions and tax benefits in the IRA for the same type of contribution (Traditional vs Roth), but there are income limits to making these contributions. The main benefit of using an IRA is investment flexibility: you aren’t restricted to the investments made in the account. You can invest in individual stocks or mutual funds or index funds of your choice.

Alexander Yuan

The post What Is The Difference Between a 401k and IRA? appeared first on Caveman Circus.

This content was originally published here.

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