3 Major Differences Between an IRA and a 401(k)

By Markets Fool.com

IRAs and 401(k)s are two of the most widely used ways Americans save for retirement, and in many ways the two types of accounts are similar. For instance, both offer attractive tax advantages that can greatly increase the size of your nest egg over time.

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But despite their similarities, there are notable differences between IRAs and 401(k)s. We asked three of our contributing writers to explain some of these differences, and what they mean to investors like you.

Jason Hall: While a 401(k) and an IRA essentially do the same thing -- that is, provide tax-advantaged ways to invest for retirement -- the biggest difference is that a 401(k) is an employer-sponsored plan with much higher contribution limits than an IRA.

If you're under 50, you can contribute as much as $18,000 in pre-tax income deductions to your 401(k), but only $5,500 to an IRA. If you're 50 or over, the limit jumps to $24,000 in your 401(k), versus $6,500 in an IRA. Not only does this higher contribution limit mean you can sock away much larger amounts, but the compounding growth of all that extra cash can make a massive difference.

Let's say you contribute $11,000 per year to your 401(k), double the amount you can contribute to an IRA, increase those contributions about 2% annually (about what the historical contribution limit increase has been), and average a conservative 7% annualized rate of return over the next 30 years. Here's how much larger your nest egg would be:

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Returns based on assumptions in paragraph above table

This doesn't even factor in the potential for free money in the form of employer contributions. If your employer matched 3% of your salary (assuming a $40,000 annual salary to start, with a 2% average annual pay increase), your nest egg would soar to over $1.6 million after 30 years.

Take advantage of the extra wealth-building power of a 401(k) if you can. It'll make a major difference in your nest egg when you reach retirement.

Dan Caplinger: One of the most important differences between IRAs and 401(k)s is the level of investment flexibility that each one offers. With IRAs, you have almost unlimited options in terms of what investments your account can hold, including individual stocks and bonds as well as mutual funds, ETFs, bank products, and a wide range of other investments that even includes gold bullion coins and real estate. By contrast, a 401(k) typically offers much more limited investment choices, with most employers only giving participants access to a short list of mutual funds and perhaps company stock.

One compensating factor in favor of 401(k)s, though, is that the mutual funds you can buy in a 401(k) are often the cheaper institutional-class shares. These special share classes are typically unavailable to individual investors, with only employers and other large investors eligible to enjoy the lower expense ratios that these funds have. That's one reason why many consumer advocates believe that unscrupulous investment professionals take advantage of those rolling money over from 401(k)s to IRAs, investing them in the same funds but using share classes with higher fees. IRAs do offer a wider selection of investment options, but if you're happy with what your 401(k) has on its investment menu, you might be better off sticking with it rather than trying to replicate it in an IRA.

Matt Frankel: One big difference between IRAs and 401(k)s is the rules that determine when you are allowed to use your money early, meaning before you reach 59 1/2.

IRAs have a few rules that many people take advantage of. For example, you are allowed to withdraw up to $10,000 penalty-free from your IRA to fund a first-time home purchase for you or one of your relatives. You can also withdraw penalty-free from an IRA to cover qualified higher-education expenses for you or your kids. And if your IRA is of the Roth variety, you can withdraw your original contributions (but not any investment gains) at any time for any reason.

401(k)s have their own early-withdrawal rules. Generally, withdrawals in the case of hardship or for education expenses are permitted, but you'll end up paying a penalty. However, if you are "separated from service" in the year of your 55th birthday or later, you may be able to access the funds in your account without penalty. And most (but not all) 401(k) plans allow you to borrow money from your account for any reason, as long as you pay yourself back. The rules regarding permissible 401(k) withdrawals and loans vary from plan to plan, so check with your plan administrator before attempting to withdraw money.

Finally, bear in mind that for any withdrawals, early or on time, the money you withdraw will count as taxable income, unless the account is a Roth IRA or 401(k).

The article 3 Major Differences Between an IRA and a 401(k) originally appeared on Fool.com.

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