Right now, you are young, healthy and energetic. But you won't always be, which is why it is important to invest in either a 401 plan or a traditional IRA. Whether you plan to work until the end of time or retire early and travel the world, financial security in your golden years will make life much more fun. Knowing the difference between a 401 plan and a traditional IRA can help you choose the best option for your life.
How to Obtain
The main difference between a traditional IRA and a 401K plan is in how they are obtained. A traditional IRA can only be obtained privately through your investment company or lending institution. A 401K plan is typically obtained through your employer; however, since 2002, self-employed individuals are allowed to obtain individual 401K plans.
Both the traditional IRA and the 401K plan have substantial early withdrawal penalties of 10 percent. You do not incur the penalty if you withdraw money for certain expenses including, health care insurance premiums, first time home purchase or to pay IRS debts. Early withdrawal from a 401K plan for college expenses will incur the 10 percent penalty; however, traditional IRA withdrawal for yourself, spouse, child or grandchild to attend college can be done without penalty. Outside of the exceptions, you will be penalized if you withdraw funds from either a traditional IRA or your 401K before the age of 59 1/2.
As of 2010, there are no income limits to open a traditional IRA or a 401K plan. There are restrictions on contributions. For a traditional IRA, you are limited to an annual contribution of $5,000 if you are under 50 or under. If you are over 50, you can contribute up to $6,000 annually. You can contribute up to 15 percent of your income to your 401K plan. In addition, some employers provide matching contributions to your 401K plans. Another difference between a 401K and a traditional IRA is that you and your spouse are each able to contribute the maximum allowable amount into the IRA, whereas, only you can contribute to your 401K plan.
You can borrow from your 401k plan. You are generally limited to borrowing no more than 50 percent of the vested account funds from the plan; you can then take up to five years to pay it back, interest and penalty free. You are not legally allowed to borrow from your traditional IRA.