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What's the difference between a 401(k) and an IRA?

A 401(k) is simply a pension plan that your employer sets up, to which you contribute from your earnings (you'll pay taxes when you withdraw from the account but get the immediate benefit of investing with pre-tax dollars). Most companies offer several investment options for your funds, including buying company stock, and many offer matching contributions -- yes, free money! -- to entice you to save. There are limits on how much you're allowed to contribute each year (up to $15,500 in 2007) and there are penalties if you withdraw money early. However, there are exceptions for the first-time purchase of a home and for educational expenses. Some companies also allow you to borrow against your account. When you leave a job, you can maintain your 401(k) as-is, as long as there is more than $5,000 in the account, or you can roll it over to a new employer's plan or to your own private account.

Individual Retirement Accounts (IRAs) are private retirement funds set up at a bank or other investment brokerage. If you don’t have a 401(k), you can contribute up to $4,000 yearly and claim a tax deduction on your annual return. You're allowed to contribute more, but the law requires you to pay taxes on the amount first. The money grows in the investments you choose, and when you reach age 59 1/2, you can start taking out the money without penalty, paying taxes on any gains.

A Roth IRA is related, but different. You're allowed to contribute up to $4,000 per year as long as you pay income tax on the money, but when you start withdrawing after age 59 1/2, you don’t have to pay taxes on the gain. Keep in mind that if your annual gross salary is above a certain amount, you're not eligible for a Roth IRA. The cutoff is $110,000 earned annually by single taxpayers, and $160,000 earned jointly by married couples. If you earn more than the cutoff, you’ll need to opt for a traditional IRA, which has no limits.

-- The Nest Editors

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