Difference between 401k and retirement plan

The Difference Between IRA & 401(k) Retirement Plans

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"The question isn't at what age I want to retire--it's at what income." - George Foreman, U.S. Olympic Gold Medalist, Heavyweight Boxing

Ready to start saving for retirement but not sure which plan is right for you? Learn more about how 401(k) and IRA plans may help you work towards your retirement goals.

What is a 401(k)?

A 401(k) is an employer-sponsored retirement plan which allows employees to contribute a portion of their paycheck towards retirement savings. Funds are invested primarily in the stock and bond markets, typically as part of a mutual fund, with the goal of increasing their value over time. Although 401(k) plans may be managed by licensed investment brokers, it is up to you to direct where and how you want your personal funds invested. Funds invested in 401(k)s are not guaranteed to increase in value and should stock prices go down, so will the value of your 401(k).

One of the most valuable features is that many employers offer matching funds for employees who contribute to the company 401(k) plan. For each dollar you contribute, your employer may contribute an additional $0.50 - $1.00, up to a set maximum.* This is essentially a 50-100% initial return on your investment--far better than what you're likely to earn investing in the market.

In return, your employer may request that you "vest" your matching funds, which means you must work for them for several years before you can collect their match. Should you leave before the vesting period is over, the company may take back a portion of its matching funds. And once you end employment with a company, you are no longer eligible to contribute to that company's 401(k) plan going forward. But no matter when or how you leave your job, you still walk away with 100% of your own contributions.

Contributions and Distributions

When you put funds into your 401(k), your contribution reduces your taxable income, potentially saving you money at tax time. Additionally, any dividend income and capital gains earned in a 401(k) are tax deferred, so, you will pay no taxes until you withdraw those funds during retirement. Should you withdraw money from your 401(k) before age 59½—with limited exceptions—you may be subject to penalties and taxes on your withdrawal for the current tax year.

Withdrawals completed before 59½ may only be made for the following reasons:

  • Hardship withdrawals

  • higher education expenses

  • first-time home purchase

  • certain unreimbursed medical expenses

It is also possible in certain circumstances to take out loans against your 401(k). But know there is risk involved in borrowing against your employer plan. Depending on the terms of the loan, you may incur a 10% penalty fee for withdrawing early or need to repay the loan in full when you leave your job. Because of this, borrowing from your 401 (k) should only be done for significant reasons and with full understanding of the implications.

What is an IRA?

An Individual Retirement Account or "IRA" is an independent retirement plan not sponsored by an employer. IRAs come in two types: Traditional and Roth.

Traditional IRA

A Traditional IRA defers taxes on your contributions until you withdraw them upon retirement. Contributions may be tax deductible if you don't have access to a company-sponsored 401(k). But if you do, Traditional IRA contributions are only deductible to a certain amount then phased out.

Roth IRA

With Roth IRAs, contributions are not tax deferred, meaning you must pay taxes on income earned before you invest in a Roth IRA. However, you may withdraw Roth contributions without paying taxes or penalties at any age for any reason. And you aren't required to make required minimum withdrawals from a Roth IRA upon retirement.

The annual contribution limit for a Roth IRA is the same as a Traditional IRA, but not everyone is eligible to contribute to a Roth plan. Your qualification depends on your annual income and whether you file taxes as part of a married couple.

Converting to a Roth IRA

Should you decide a Roth IRA is the appropriate plan for your retirement needs, converting to a Roth plan involves accounting for the unpaid taxes on your retirement funds when filing income taxes. Consult with a professional tax advisor for more information about the tax implications, age, and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation.

Retirement Plan Contributions Compared
401(k) Traditional IRA Roth IRA
Tax deferred contributions
Yes
Yes
No
Impact on income taxes
Yes
Yes
No
Income limit for contributions
No
No
Yes
Employer matching funds
Maybe
No
No
Employer-dependent
Yes
No
No
Required minimum withdrawals upon retirement
Yes
Yes
No
Receive loans from plan
Yes
No
No

Depending on where you work and how much you earn annually, you may be able to contribute to both a 401(k) and an IRA plan. Consult with an investment advisor about your financial goals before deciding how to allocate your retirement savings.

Saving for Retirement? We Can Help!

Whether you've recently started your first job or are just around the corner from retiring, the Financial Advisors** from BECU Investment Services can help you create a personal retirement plan portfolio. Click here to set up a complimentary consultation or call 206-439-5720.

Stock and mutual fund investing involves risk including loss of principal.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

*CNN Money. "Ultimate guide to retirement: What's a matching contribution?"

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