The Difference Between a Simple IRA & a 401(k)

Most investment advisors recommend conservative investments for retirement.
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Traditional and Roth Individual retirement accounts (IRA) are available to almost all taxpayers who have earned income, providing tax-deferred retirement options. You may also be able to take advantage of certain employer-sponsored retirement programs, such as a SIMPLE IRA or 401(k) plan. Understanding the difference between these two investment vehicles is critical for long-term growth.


Company sponsored retirement programs are nothing new. Pension plans date back at least as far as the middle of the 19th century. Retirement programs that offer substantial tax advantages to companies for providing them is a more recent development. Tax advantaged pension and profit-sharing plans were first introduced in the United States in the late 1920s, and the first individual retirement arrangements (IRA) were authorized by Congress in 1974 as part of the Employee Retirement Income Security Act. Subsequent legislation further expanded individual retirement programs to include most working taxpayers, and created new programs for both small and large employers including SIMPLE IRAs and 401(k) programs.


SIMPLE IRA plans are limited to small businesses that employ no more than 100 employees, although certain other qualifications apply. 401(k) plans are available to both small and large businesses. An employer who establishes a SIMPLE IRA plan must establish an IRA for each eligible employee. An employer who establishes a 401(k) must make the plan available to all eligible employees, but the employee may elect whether or not to participate in the plan.


Qualified employees can make pre-tax, salary-reducing contributions to either a SIMPLE IRA and a 401(k) plan, whichever is offered by their employer. The employer must make a matching contribution into the employee's account up to a certain percentage, as defined by the plan. Contributions to each of these plans reduce the employee's taxable income by the amount of the contribution, which reduces the employee's tax burden. Employer contributions are not counted as taxable income in the year they are made. Funds contributed into these accounts, including any growth due to interest or dividend payments or capital gains are not subject to income taxation until they are withdrawn.


Funds contributed into a SIMPLE IRA or a 401(k) plan retain their tax-deferred status until they are withdrawn, at which time they are treated as ordinary income to the taxpayer. Funds that are withdrawn before the taxpayer reaches the age of 59 1/2 years are considered to be an early withdrawal, and are subject to an additional 10 percent tax penalty. Taxpayers who are less than 59 1/2 years old may be able to withdraw funds early without a tax penalty under certain hardship conditions which vary depending upon the type of account that holds the funds. Hardships may include excessive medical expenses, funeral expenses, educational expenses or to purchase a home.

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