What is the difference between an IRA and 401K?

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In today’s uncertain economic climate, careful, well-planned retirement savings today will help to provide financial security in the future. Individual Retirement Accounts, better known as IRAs, and 401Ks are the two most popular vehicles offered for retirement saving. Understanding the differences will help decide which product best serves individual needs.

An IRA is a retirement savings account which can be opened at almost any bank, investment firm, or insurance brokerage house. They are often offered to employees by employers.

IRA Quick Facts

  • Anyone can open an IRA (earned income is required from sources such as wages, tips, salaries, and self-employment )

  • No income limitations

  • 2013 Maximum Contribution is $5,500 ($6,500 for 50 and older)

  • Contributions are Pre-tax

  • Contributions are 100% deductible if certain conditions are met

  • Contributions in the year a person reaches 70 1/2 (and subsequent years) is no longer available

  • Distributions can be taken anytime

  • Distributions are required to begin the year a person attains 70 1/2

  • Federal taxes are paid when distributions begin

A 401k is an employer sponsored retirement savings plan, designed to help employees save for the future. Funding comes from employee and employer contributions made on a pretax basis. The plan contributions are invested in mutual funds and diversified across risk categories as selected by each employee.

401K Quick Facts

  • A 401K is employer sponsored

  • Contributions may be pretax or after-tax

  • Employer contributions

  • Flexibility to change how you want your contributions invested

  • 2013 maximum contribution is $17,500

  • Distributions require a specific event to occur: Retirement, death, disability, separation from employer, reach 59 1/2 years old, or hardship (if your company plan provides for hardship cases)

  • 10% Penalty on early distributions taken before the age of 59 1/2

  • Ability to borrow against your 401K in the form of loans

  • No mandatory withdrawals at 70 1/2 if certain conditions are met

In the end, one might ask, which is the best option? The answer depends on your anticipated retirement income needs. New savers whom have limited disposable income may opt for an IRA and adopt a slow and steady attitude to saving.

Whereas, an individual who is anticipating a major reduction in income upon retirement, may choose an IRA simply because the mandatory withdrawals will be tax free, thus, increasing the amount of disposable income available to provide for living expenses.

A 401K company-match or profit-sharing program is attractive to many. A young person just starting out can jump start his retirement savings by taking advantage of a 401K company- match program using pretax dollars to reduce the amount of federal tax paid. During one’s middle career, income should increase causing the amount saved as percentage of income to also increase.

For late career entrants a 401K is a vehicle to catch up on delayed retirement savings. 401Ks offer a lot of flexibility by allowing participants to direct the level of risk associated with earnings: low, medium, and high. Those who are not comfortable with high risk investments will experience slower earnings growth rates, whereas a high risk account may experience quick growth.

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