When you've decided that it's time to start saving up for your retirement, you will need to look at your investment options. Two of the most retirement investment options are the 401(k) and the individual retirement account (otherwise known as an IRA). Whether or not you are eligible for a 401(k) mainly depends on whether your employer offers one. Either way, you can choose to set up an IRA as your primary savings plan or use it to supplement what you set aside with your 401(k).
Pros
The main perk of 401(k) plans is that many companies offer to match a portion of (or all of) what employees put into their accounts. This translates to free retirement money. The main perk of having an IRA is that it allows account holders to have more control over their accounts. Account holders can choose where they will invest (e.g. funds, stocks,) and, depending on what type of IRA they choose, they may even be able to decide when they pay taxes on their deposits.
Cons
Since companies can choose the funds that are a part of their plans, some 401(k) plans will only offer employees a very select number of funds to choose from. IRAs offer more flexibility when it comes to choosing where to invest, but this flexibility requires that account holders carry a lot more responsibility. They must choose where and how much that they want to invest, or hire someone to do that job for them.
Contribution Limits
Both plans have limits on how much pre-tax money can go into them every year. The annual maximum is higher for the 401(k) than for the IRA. For example, in 2009, the annual 401(k) contribution limit for people 49 and under was $16,500 and $22,000 for people 50 and over. However, some employers may place limits on their employees' 401(k) limits, such as up to 10 percent of salary. The 2009 annual IRA contribution limit was $5,000 for people 49 and under, and $6,000 for people over 50. Both programs increase limits based upon inflation.
Withdrawals
Both 401(k) plans and traditional IRAs allow account holders to make pre-tax contributions, but all retirement withdrawals will be taxed income. Fortunately, interest will have accrued by this point and most retirees are in a lower tax bracket than they were when they contributed to their retirement accounts. Both accounts also set limitations on when any money can be withdrawn. Most 401(k) plans allow account holders to borrow money under circumstances such as medical emergencies as long as the money is paid back. However, penalties ensue if account holders don't pay money back or if they withdraw money for retirement before they turn 59-and-a-half. IRAs don't allow account holders to borrow any money and they also penalize withdrawals prior to age 59 1/2. Both accounts require account holders to start withdrawing money by age 70 1/2.
Roth IRAs
Roth IRAs are individual retirement accounts that allow account holders to pay taxes up-front in order to avoid having to pay taxes on withdrawals. However, Roth IRAs also come with their own eligibility requirements and penalties on early and late withdrawals.
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