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Both the IRA (Individual Retirement Account) and the 401k are ways to save money for retirement, or occasionally for major purchases such as the college education of a child or a down payment on a house. The principle difference between the two is that 401ks are retirement saving plans offered through your employer, and the IRA is a plan you set up on your own, with the help of a bank, mutual funds or other financial agency. Some people have no option for savings but to open an IRA. If a person is self-employed, owns a business or freelances, he or she may not have access to opening a 401k. You generally need to be employed by a company that offers a 401k savings plan to have one.
There are some differences between the IRA and the 401k. Some people have both because of one of the major differences between the plans. A 401k may have a maximum savings amount or a maximum percentage of your salary that you can place in an account. You might be limited to a 10% contribution of your salary, and as of 2008, the maximum tax-free amount you can place in a 401k is $16,000 US Dollars (USD). This will adjust each year if inflation occurs. A benefit to the 401k that the IRA doesn’t have are employer-matching programs.
Employers often offer to match some or all of what you invest in your 401k. This may be either half of you invest, up to six percent of your salary. If you invest 6% of your $100,000 USD salary per year, $6000 USD, a company might completely match that $6000 USD investment, giving you $12,000 USD total in investments. Recall that this money is not taxable unless you remove it, and you may be able to avoid taxes on it entirely if you spend it on certain allowable expenses.
Non-taxable IRA contributions are lower than those for people who invest in their 401k. In 2008, for instance, you could claim up to $5000 USD of your income as nontaxable if invested in an individual retirement account. Sometimes people invest their taxed income in a Roth IRA. Since it has already been subject to tax, it isn’t taxed when it is removed. It can be slightly more challenging to remove money from your independent retirement account without paying heavy fines, but it may be slightly easier to change the way your invested money is distributed.
Money in 401ks and IRAs may be diversified into stocks, bonds, and mutual funds. If you don’t like how something is performing, usually you can change the way your money is distributed more easily in an IRA. Some 401ks limit the number of times per year you can make changes. On the other hand, some 401ks have caught on and now allow employees to actively manage their investments on a regular basis.
You can generally funnel more money into IRAs than a 401k, though you get less tax benefit from it. Yet the advantages of the 401k are many: chief among them is the employee-matching program, which might double the money you invest. However, if you plan on retiring early, you may need to use both types of savings accounts to boost the amount of money available to you when you retire. Many people who have larger incomes and larger amounts of money to invest use a combination of 401k investments and Roth IRAs.