The traditional 401(k) and the traditional IRA are two of the most commonly used retirement accounts that people use to save for the future. Generally, both accounts allow you to shelter your savings and earnings from taxes until you start taking withdrawals, which will be taxed at your ordinary income tax rate.
But while these accounts operate similarly, they're governed by different rules that give them distinct pros and cons. Here are five that stand out.
1. Deductibility of contributions
One nice feature of the traditional IRA is that anyone with earned income can make a contribution to the account -- though not everyone can deduct their contribution from their taxable income. To verify whether or not you can deduct your IRA contribution, see this IRS chart if you are also covered by a retirement plan at work, or see this IRS chart if you earn income but do not have access to a workplace retirement account.
Meanwhile, anyone who is an active participant in a workplace 401(k) can make pre-tax contributions, regardless of their income, thereby lowering their taxable income.
2. Contribution limits
When it comes to tax-favored savings accounts, the government typically imposes yearly contribution limits, restricting how much you can sock away. By far, the savings advantage is with the traditional 401(k): In 2017 you can contribute up to $18,000 to a 401(k) if you're under age 50, while those aged 50 or older can contribute an extra $6,000 for a total of $24,000.
On the other hand, for 2017, you can put only $5,500 into a traditional IRA, and the 50-and-up crowd can contribute an extra $1,000.
3. Employer match
One industry-standard piece of advice is that regardless of whether you're saving enough for retirement, you must contribute enough money to your 401(k) to receive the full match that your employer offers (if any). That match is free money, and it gives you an instant return of 50% to 100% (depending on the size of the match) on your investment. There's no beating that!
Unfortunately, you can't find that sort of free lunch outside the 401(k). When you save in an IRA, there won't be any outside benefactor pitching in for you, so you'll have to do the heavy lifting.
4. Allowance of loans
In general, it's never a good idea to borrow from your future self, as you can't get back the time that your money could have spent invested and growing. But desperate times call for desperate measures, and you may someday feel the need to raid your retirement savings in order to prevent an even greater financial calamity. Here's where you'll find another big difference between the traditional 401(k) and the traditional IRA.
If your workplace plan allows for it, you can take a loan from your 401(k). In short, when you pay the loan back, you essentially pay yourself back with interest. However, you pay the loan back with after-tax dollars, thereby lowering your monthly take-home pay. Additionally, there are usually very specific guidelines you'll need to follow, and if you leave the company before the loan is paid back, you may be given a very short amount of time to repay the loan. Any amount you haven't repaid within that window will be considered a distribution and will be subject to a 10% penalty. For more detailed information about how this process works, see this article.
On the other hand, there is no such loan provision for a traditional IRA. If you need to take out money from your IRA, it will be deemed a distribution -- and not a loan that you can repay to yourself. And since there are yearly contribution limits, once you remove that money, you essentially lose out on contribution years. For example, if you contribute $5,500 for 2017 and then take it out next year, you have lost the opportunity to contribute for the year 2017. And if it is considered a premature distribution (generally before you are age 59-1/2), not only will you owe income taxes on the money, but you will be charged a 10% penalty as well.
As a final note, under certain circumstances, the IRS does allow you to take an early withdrawal from either a traditional 401(k) or traditional IRA penalty-free (although never income-tax-free).
5. Investment options
While you may be able to contribute more to a 401(k) than to an IRA on a yearly basis, in most cases, you have very limited investment options within a 401(k) plan, which is another big difference between the two types of accounts.
With an IRA, you have almost unlimited investment options and control over fees and expenses. So depending on your company's 401(k) plan and the investment offerings and associated fees, you might want to direct some money into an IRA to diversify your portfolio.
Ultimately, both the traditional 401(k) and traditional IRA exist to help Americans save for the future, and we will continue to rely upon these accounts to hold our primary retirement assets. And as such, it's wise to know the specific rules and regulations that govern these accounts.
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