Retirement Basics: IRA or 401(k)?

How to Choose Between a SEP IRA or Solo 401(K)

There are many similarities between a 401(k) plan and an individual retirement account. But there are also differences that can make them more difficult to understand. If you get these two retirement savings vehicles mixed up, or you don't fully understand what they are, you're not alone. IRAs and 401(k) accounts are confusing to lots of Americans.

To help you understand the basics, we'll answer these questions: who, what, when, where, why and how?

Who Can Participate?

  • IRA: Anyone under the age of 70½ who earns an income can participate in an IRA. In addition, if you have a non-income-earning spouse and you file a joint tax return, you can make an IRA contribution for that spouse as long as your income is more than the contribution. IRAs do have income limitations when it comes to certain tax benefits, though. Some high-earning individuals and married couples won't be able to take advantage of all the tax benefits of an IRA.
  • 401(k): You must work for an employer who provides a 401(k) plan to have an account. Furthermore, 401(k) plans are a benefit, so your employer can place limitations on who can participate and when.

What Are These Accounts?

IRA and 401(k) accounts are two retirement vehicles that, along with a few others, have tax benefits designed to help Americans accumulate more money for retirement.

  • IRA: No one will automatically sign you up for an IRA account, and these accounts are not related to your employer. The account owner makes traditional IRA or Roth IRA contributions, and can select any combination of investments the platform allows. Traditional IRA contributions aren't payroll deductions, so they're not technically made pretax. Rather, income-eligible account owners may take tax deductions for traditional contributions. Roth IRA contributions aren't tax deductible.
  • 401(k): If you have access to a 401(k) account, it's through an employer-sponsored plan. Some employers have automatic enrollment, and even automatic contribution increases. Contributions are made via payroll deduction; traditional contributions are made pretax and reduce your taxable income, and Roth contributions are made after-tax.

When the account owner reaches retirement age and begins taking distributions, money contributed to an IRA or 401(k) account on a traditional basis will be subject to ordinary income taxes. The amount of your tax liability will be dependent on whether contributions were made with pretax or after-tax money. Any money contributed to a Roth IRA will not be subject to additional taxes as long as certain requirements are met.

When Do You Take Distributions?

The IRS allows account owners to begin taking penalty-free distributions from IRAs and 401(k) accounts at age 59½. There are exceptions, so consult with a tax adviser regarding your personal situation. With a 401(k) plan, the employer may place stricter guidelines on distributions while you are still working. The IRS requires that distributions start by the April following the calendar year an account owner turns 70½, and then they occur every calendar year after age 70½.

Where Can You Put Your Money?

  • IRA: Financial institutions that offer IRAs often provide access to virtually any securities investment. Sometimes there are restrictions and limitations, so research several options for your IRA.
  • 401(k): Employer-sponsored plans like a 401(k) offer a limited number of investments, usually an array of mutual funds from several asset classes and sectors. You may also have a brokerage option that would grant access to additional investment options, but that may come with extra fees or expenses within the 401(k) setting.

Why Do Contribution Limits Change?

IRA and 401(k) account contribution limits may increase or remain steady from one calendar year to the next. The IRS increases limits as needed for each plan in an effort to keep pace with inflation.

How Much Can You Contribute?

  • IRA: In 2015, most retirement savers can contribute up to $5,500 to an IRA. If you're age 50 or older, you can catch up with an extra $1,000, so your maximum allowable contribution is $6,500. From the year you reach age 70½ onward, you can't make traditional IRA contributions, but you can make Roth contributions. Your ability to take tax deductions on these contributions can be limited by your marital status, your income and whether you have access to a retirement plan at work.
  • 401(k): In 2015, most retirement savers can contribute $18,000 to a 401(k) account; those age 50 and older can contribute an additional $6,000.

As always, consult a tax adviser during the process of deciding how much to contribute to or take out of a retirement account.

Nothing in this article should be construed as tax advice. Contact a qualified tax professional to discuss any tax matters relating to your retirement plan and investment option.

Updated on July 7, 2015:This story was originally published onFeb. 6, 2013, and has been updated to include current contribution limits.

Copyright 2015 U.S. News & World Report

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