What is a 401K Plan and IRA?

A 401k plan is a retirement plan sponsored by employers. Employees may choose to have a portion of their salary deferred to any of the 401k investment choices selected by the employer. The employer may also contribute to the employee’s 401k by matching a portion of the investment (for example, $.50 for every $1.00 the employee invests). The investments to which money is deferred may include stocks, bonds, money market funds, and company stocks. Monies deferred into the 401k are allowed to grow tax-free, and these monies are subtracted from the employee’s taxable income. The maximum amount allowed to be contributed to a 401k changes annually. If money is withdrawn from the 401k before the employee turns 59 1/2, the individual may have to pay penalties. If the individual changes jobs, the monies in the 401k may be rolled over to a 401k of the new employer or to an Individual Retirement Account (IRA).

A defined benefit plan usually links the benefit to the amount of service and is based on the final average salary. Employees can usually predict the monthly retirement income they might receive with this type of plan and might also be given the choice of a lump-sum benefit at retirement.

A defined contribution plan is not a defined benefit so the employee cannot predict a monthly retirement income. If an employee leaves the company, they usually receive the proceeds in a current or deferred lump sum or annuity.

Companies are prohibited by law from tapping into the money in their 401(k). But if your company goes bankrupt and you have 401(k) money invested in their stock fund you will likely lose that money.

Individual Retirement Account (IRA)

An Individual Retirement Account allows individuals who are earning income to contribute to a tax-deferred investment fund. An individual can contribute up to $2,000 per year or $4,000 if married to an unemployed spouse. Contributions to an IRA are tax-deductible based on the individual’s marriage status and income level. Monies contributed to an IRA may be invested in stocks, bonds, mutual funds, annuities, bank savings accounts, Certificates of Deposit, government bonds, and investment trusts but not more personal and immediate investments such as a home or collectibles. The individual may contribute to the Individual Retirement Account until age 70 1/2, but if money is withdrawn before age 50 1/2, penalties will be incurred.