IRAs and How They Are Different From 401(k)s

IRAs, or individual retirement accounts, are very similar to 401(k)s, which I discussed here yesterday. They are also a retirement plan where you invest your money in various things such as stocks and bonds. As with 401(k)s, there are also penalties if you start withdrawing before you are 59.5. You must make regular withdrawals starting when you are 70.5 or half of your mandatory withdrawal amount will be taken as a penalty.  

So what are the differences between the two? Well, to start, the maximum contribution for an IRA is much lower than a 401(k). For 2009, the maximum amount a person under 49 can contribute is $5,000; the maximum for those 50+ is $6,000. You are not allowed to borrow money through an IRA. IRAs are run through banks and brokerage firms rather than the company you work for. This CAN (though it is not guaranteed) lead to a larger variety of investment options. You also can adjust your investments whenever you want, whereas many 401(k)s will only let you change your investments periodically. The money that you are allowed to put into an IRA is limited essentially to money that you would earn at a job (wages, commissions, bonuses, etc). Things such as dividends, profit from stock trading, money from renting property, etc. cannot be deposited into an IRA. Therefore, if you make $3,000 from a job and $40,000 from the stock market, you cannot deposit the maximum amount of $5,000. Only the $3,000 is eligible for the IRA.

Another important distinction to note is the ability to deduct the money from your taxes. When you invest money in a 401(k), the money is taken from your paycheck before you even pay income taxes. When you invest in an IRA, you put the money down on your tax form as a deduction. Depending on the amount of money you (and possibly your spouse) makes, you might only get a partial, or even no deduction. If you get no deduction, the benefits of using an IRA are drastically reduced. 

Also consider whether your employer offers a 401(k). If they are willing to match the money you put in, that might be a better choice because you'll be putting more money in, which means more money will accumulate. However, if the money would not be matched and you would qualify for the tax deduction, maybe the ability to invest in a greater variety of options and be able to change your investments at will makes an IRA a better choice for you.