Often people use the account names “401K” and “IRA” as though they are the same thing. This post will help to clear up what exactly is meant by a 401K vs. an IRA account and other retirement options.
401K or IRA
First, both of the terms 401K and IRA refer to retirement plans. They have some similarities, but they are not the same thing! For starters, a 401(K) is specifically the name of a particular type of employer-sponsored retirement plan. In this type of account, you contribute money from your paycheck into a tax-deferred retirement account. The rules for a 401(K) account are set out in the IRS regulations, and 401(K) refers to the section of those laws which set up this type of account. The term IRA is sometimes used for any kind of retirement account, as it stands for “individual retirement account”. However, the IRA is mainly meant to refer to what is called a traditional IRA, where you can contribute money even if your employer does not have a plan, and you can deduct the money from your taxes, so there is still a tax advantage to depositing money. For both of these accounts, you don’t pay taxes on the money you contribute, but you will pay taxes at the time you withdraw in the future, at whatever your taxable rate is at that time.
Most of the time, it maybe easier to use the 401K if you have one at work. Many employers offer these, but many do not. If you do have such an account at work, your employer may also provide a “match”, which means they contribute money to match the amount you deposit, up to a certain limit. You can find details about this from your human resources person. With a 401K account, the money is taken automatically from your paycheck, so you don’t have to have as much discipline to remember to deposit on your own. It can be easy to fund this way.
For an IRA, though, you can deposit up to certain limits each year, and you can also fund a spousal IRA for your spouse, even if he or she is not working. There are also limits to the contributions on a spousal IRA. With an IRA, you can open this account at a bank or brokerage of your choice, but be sure to ask what options you have to invest. Many times, you will want to go with a broker who can set up a self directed IRA where you can invest in stocks, bonds, mutual funds and other vehicles. Some banks will only offer a selection of mutual funds, which isn’t always the best way to invest. Especially in volatile or uncertain markets, go with an account where you can move money to the right place depending on where the best investment choice is for you.