The Nest

Monday, October 15, 2007 12:04 PM

What's the difference between a 401(k) and an IRA?

The Internal Revenue Service wasn’t so creative when it came up with a name for a retirement plan offered by an employer. A 401(k) is simply a pension plan account that your employer sets up for you and that you contribute to with money from your earnings before taxes are taken out (you pay the taxes when you withdraw the money).

Most companies offer several investment options for your funds, including buying company stock, and many offer matching contributions -- yes, free money -- to entice you to save. There are limits on how much you can contribute each year (up to $15,500 in 2007) and there are penalties if you take out money early. However, there are exceptions for the first time purchase of a house and for educational expenses, and some companies allow you to borrow against your account. When you leave a job, you can maintain your 401(k) as is, as long as it has more than $5,000 in the account, or you can roll it over to a new employers plan or to your own private account.

An Individual Retirement Account (IRA) is what that private account is called, and it’s what you set up with a bank or other investment brokerage. If you don’t have a 401(k), you can contribute up to $4,000 and claim a tax deduction on your annual return. You can contribute more, but you have to pay taxes on the amount first. The money grows in the investments you choose, and when you reach age 59 1/2, you can start to take out the money without penalty, paying taxes on any gains.

A Roth IRA is related, but different. You can contribute up to $4,000 as long as you pay income tax on the money, but when you take the money out after age 59½, you don’t have to pay taxes on the gain. Keep in mind that there are Roth IRA eligibility issues. If your annual gross salary is above a certain amount, you are not eligible to contribute to a Roth IRA. The cutoff is $110,000 for single taxpayers, and for married couples jointly earning over $160,000. In that case, you’ll need to opt for a traditional IRA, which has no limits.