What Is an IRA 401k?

IRA Background

The individual retirement arrangement was first authorized as a tax break for working people in 1974 as part of the Employee Retirement Income Security Act. The intent was to provide workers who were not covered by traditional pension plans at work with an incentive to save money for their retirement. The ability of workers who are covered by a pension plan at work, including a 401k, to make tax-deductible contributions to IRAs is limited.

Traditional IRAs allow their owners to deduct contributions. Assets grow tax deferred. Withdrawals are taxed as income. Withdrawals prior to age 59-and-a-half are assessed a 10 percent penalty except in certain circumstances, such as hardship, disability, college expenses or a down payment of up to $10,000 on a home. The account owner must begin making taxable withdrawals, or minimum required distributions, after age 70-and-a-half. Roth IRAs do not allow for a tax deduction for contributions, but earnings grow tax free. There is no requirement to make RMDs.

The 401k is named after a section in the tax code that allows workers to defer income if they set it aside for their own retirement. The 401k was originally popular among executives in high tax brackets, but eventually became a popular savings vehicle for workers at all income levels. Many companies provide an additional incentive by matching a portion of the employee's contributions to the 401k.

A 401k is taxed in much the same way as traditional IRAs. No income tax is paid on contributions to the 401k. The balance grows tax deferred until retirement, and withdrawals are taxed as income. A 401k plan also has RMD requirements similar to IRAs. Withdrawals prior to age 59-and-a-half may incur a 10-percent penalty. The plan sponsor must withhold 20 percent of any withdrawal to pay income tax. Some 401k plans allow workers to borrow from their 401k balances. There is no tax on this borrowed money, but the borrower must repay the loan, with interest, within five years, or the IRS will deem the loan to have been a distribution. Taxes and penalties will apply.