401(k) versus IRA – why should you care?

One of the biggest questions surrounding retirement prep (next to the obvious “how much do I need to save for retirement?”) is “what’s the difference between a 401(k) and an IRA?” So I figured I’d drop a line about that here. But the differences between these two retirement accounts is more than will really fit in a few paragraphs, so let’s just tease out the fundamentals.

A 401(k), in brief, is a type of retirement account modeled after Section 401(k) of the Internal Revenue Code, which allows employees to avoid tax on “deferred compensation” – i.e. compensation that is set aside for later, typically for retirement. These accounts are set up by an employer to allow employees to put part of their paycheck into a tax-free fund for retirement.

An IRA, or individual retirement account, is not set up through an employer – rather, you set it up on your own and it is managed by some third-party institution such as a bank or brokerage. The term “IRA” is therefore very broad, and can refer to a wide variety of accounts and investment structures. Like a 401(k), however, an IRA will typically have tax advantages.

The table below summarizes many of the important distinctions – probably the biggest overall difference, however, is that one of these accounts is set up through your employer, whereas the other is set up independently by you.

Differences between 401(k) and IRA accounts include administration, loan policy and contribution limits

One key similarity between 401(k)s and IRAs is that they both come in two “flavors,” so to speak – traditional and Roth.

Traditional plans allow for tax-deductible contributions, and you’ll eventually pay tax on the withdrawals; whereas contributions to Roth plans are made after taxes, but the withdrawals are tax-free if they meet certain qualifications.

Like many investment decisions, the choice between a 401(k) and IRA is not cut-and-dried. Both have advantages and drawbacks, and the question of which is better varies from one person to the next.

– Graham