What is the difference between a 401(k) and an individual retirement account (IRA)?

A 401(k) and an Individual Retirement Account (IRA) are both retirement savings vehicles that offer tax advantages, but they differ in terms of eligibility, contribution limits, and management.

1. Eligibility: A 401(k) is an employer-sponsored retirement plan, which means it is offered by your employer as part of your benefits package. Eligibility for a 401(k) is typically determined by your employer’s requirements, such as length of employment or minimum number of hours worked. On the other hand, an IRA is an individual retirement account that can be opened by anyone who has earned income, regardless of whether they have access to an employer-sponsored plan.
2. Contribution Limits: The contribution limits for 401(k)s and IRAs differ. As of 2021, the annual contribution limit for a 401(k) is $19,500 for individuals under the age of 50. If you are 50 or older, you can make an additional catch-up contribution of up to $6,500, bringing the total limit to $26,000. The contribution limits for IRAs are generally lower. As of 2021, the annual contribution limit for a traditional or Roth IRA is $6,000 for individuals under 50, with a catch-up contribution of $1,000 for those 50 or older.
3. Employer Contributions: One significant advantage of a 401(k) is that many employers offer matching contributions. This means that your employer will contribute a percentage of your salary to your 401(k) account, often up to a certain limit. This is essentially free money and can significantly boost your retirement savings. With an IRA, there are no employer contributions since it is an individual account that you manage yourself.
4. Investment Options: Another key difference lies in the investment options available. 401(k) plans typically offer a limited selection of investment choices, typically a menu of mutual funds or target-date funds selected by the plan administrator. IRAs, on the other hand, offer a broader range of investment options, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and more. IRAs provide greater flexibility and control over how your retirement funds are invested.
5. Withdrawals and Taxes: Both 401(k)s and IRAs offer tax advantages, but the timing and taxation of withdrawals differ. With a traditional 401(k) and traditional IRA, contributions are made with pre-tax dollars, which means they reduce your taxable income in the year of contribution. However, when you withdraw money from these accounts in retirement, the withdrawals are taxed as ordinary income. In contrast, Roth 401(k)s and Roth IRAs are funded with after-tax dollars, so contributions don’t provide an immediate tax break. However, qualified withdrawals from Roth accounts are tax-free in retirement, including the earnings.

It’s important to note that retirement accounts are subject to specific rules and regulations set by the Internal Revenue Service (IRS). The rules may change over time, so it’s always a good idea to consult with a financial advisor or tax professional to understand the current guidelines and determine which retirement savings vehicle is most suitable for your circumstances.