By Kathryn Hauer, CFP
Learn more about Kathryn on NerdWallet’s Ask an Advisor
The rules for retirement plans can be confusing. Differing limits and requirements relating to contributions, withdrawals, income and taxes make it difficult to determine the best place for your savings. There are entire courses dedicated to the intricacies of the various plans, but you can get a good idea of the basics with just a few key details.
So what’s the difference between a 401(k) and an IRA? For starters, a 401(k) is a retirement savings plan offered to you through your work and managed by your employer. An IRA, on the other hand, is a retirement savings plan that you set up and manage by yourself.
There are two primary types of IRAs: traditional and Roth. The main differences between them lie in when you pay tax and what you pay tax on. With a traditional IRA, you get to defer your taxes. Tax deferral means that you don’t owe taxes this year on the money you just contributed (so your 2015 tax bill is reduced), but you will owe taxes on money you take out of the account later on. The assumption is that you will be in a lower tax bracket when you withdraw the money in retirement, so you end up paying less in taxes than if you had paid the tax upfront. With a Roth IRA, you pay taxes on your contributions, but not on your withdrawals.
These plan types also differ when it comes to the contribution and income limits. The chart below is not exhaustive, but it illustrates how tax treatment, income and contribution rules vary across the most common retirement plan types:
|401(k)||Traditional IRA||Roth IRA|
|Tax treatment||Contributions are tax-deferred. meaning you put in money that you have not paid income tax on — at least not yet. When you make withdrawals from the account later on, you pay taxes on the money you take out — both your contributions and any investment earnings (in the form of interest, dividends or gains).||As with a 401(k), your contributions are tax-deferred. You put in money that you have not paid income tax on (yet), and you pay taxes on the money you withdraw later (both contributions and earnings).||Contributions are post-tax. You put in money that you have already paid tax on. That means your taxable income is not reduced, as it would be with traditional IRA or 401(k) contributions. Your withdrawals during retirement are tax-free. The great benefit of a Roth is that you don’t have to pay tax on investment earnings in your account, as you would in a traditional IRA.|
|Contribution limits||The most you can contribute to a 401(k) in 2015 is $18,000.||The maximum tax-deferred contribution for 2015 is $5,500. If you are covered by a retirement plan at work — such as a 401(k) — there may be a limit to how much of your contribution is tax-deferred, depending on your income (see below).If you are not covered by a retirement plan at work, you can contribute the full amount tax-deferred.||The maximum contribution for 2015 is $5,500. However, if your income exceeds certain limits (see below), your allowable contribution may be reduced or eliminated. (However, it is possible to convert a traditional IRA into a Roth IRA even if your income exceeds the limit.)|
|NOTE: The $5,500 annual maximum is a combined limit for all of an individual’s IRAs — both traditional and Roth. In other words, you can put a total of $5,500 in your IRAs, not $5,500 in each.|
|“Catch-up” contributions||If you are 50 or older, you can contribute an additional $6,000 to your 401(k) in 2015.||If you are 50 or older, you can contribute an additional $1,000 this year.||If you are 50 or older, you can contribute an additional $1,000 this year.|
|NOTE: As with the regular contribution limit, the $1,000 cap on catch-up contributions is a combined limit that applies to all of an individual’s IRAs.|
|Income limits||No income limit. Anyone can contribute the maximum.||If you are covered by a retirement plan at work and your income is more than $61,000 if single or $98,000 if married, then your tax-deferred contribution will be limited — the higher your income, the less you can contribute tax-deferred. If you make more than $71,000 if single or $118,000 if married, none of your contribution is tax-deferred.If you are not covered by a retirement plan at work, then you can make the full tax-deferred contribution, regardless of income.In either case, you can contribute money on top of your tax-deferred contribution — even over the $5,500 limit — but the excess is not tax-deferred. (It makes little sense to contribute beyond the tax-deferred limit because you don’t get the tax benefits and your money is tied up for a long time.)||If you’re single, your allowable Roth IRA contribution is reduced if you make more than $116,000 a year, and you can’t contribute at all if you make more than $131,000. If you’re married, the corresponding limits are $183,000 and $193,000. These limits apply regardless of whether you are covered by a retirement plan at work.|
|Withdrawals||In general, withdrawals (aka “distributions”) are taxed as ordinary income. Withdrawals before age 59½ are subject to an additional tax penalty, although that penalty may be waived in certain cases.||In general, withdrawals are taxed as ordinary income. Withdrawals before age 59½ are subject to an additional tax penalty, but the penalty can be waived in certain cases.||Withdrawals of contributions are untaxed. Withdrawals of investment earnings are untaxed if made after age 59½ and you have had the Roth IRA for at least five years. In general, withdrawals of earnings before age 59½ are taxed, and an additional penalty may apply.|
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