IRAs and 401(k) Plans: Different Rules, Different Worlds
At their core, IRAs and 401(k) plans operate in a similar fashion. Contributed dollars avoid taxation until they are withdrawn at some point in the future. Also, Roth is available in both IRA and 401(k) form. Roth dollars grow tax-free under both the IRA and 401(k) umbrella. It is these fundamental similarities that create a false narrative that IRAs and 401k) plans are essentially the same. This could not be further from the truth. There are significant differences between the two. Here are just a few of those variations:
Contribution Limits
The maximum IRA contribution in 2025 is $8,000. This includes the $1,000 catch-up for those age 50 and over. The maximum 401(k) contribution is significantly higher – $77,500 for those age 50 and older, and a whopping $81,250 for those aged 60 – 63 using the “super catch-up.”
10% Penalty Exceptions
There are currently 20 exceptions to the 10% early withdrawal penalty for those under age 59½ (with a 21st coming on-line in late December). Of which, three apply to IRAs only: higher education, first-time homebuyer, and health insurance if you are unemployed. All the rest apply either to plans only, or to both IRAs and plans. If the goal is to leverage an exception, it is imperative to know which exceptions apply to which type of account.
Qualified Charitable Distributions (QCDs)
You can do a QCD from an IRA, but you cannot do a QCD from a 401(k) plan.
Loans
You can take a loan from a 401(k) plan (if the plan is designed to allow loans). You cannot take a loan from an IRA (not counting using IRA funds during a 60-day rollover).
Excess Contribution Correction/Penalty
If an IRA owner mistakenly contributes more than the allowable limit, we have an excess contribution. The penalty is 6% if the excess is not timely corrected. With a “timely” correction, the excess is typically removed from the IRA, along with the earnings, by October 15 of the year after the year of the excess. With a 401(k), the corrective process is completely different. The deadline for correction is April 15 after the year of the excess contribution. If the excess contribution is not removed from the plan by the deadline, those dollars remain in the plan! The fallout is double taxation. The excess 401(k) contribution must be reported as taxable income for the year of the excess contribution, and those dollars are taxed again upon distribution from the plan.
Pro-Rata Rule
When an IRA contains after-tax (non-deductible, non-Roth) dollars, every distribution (barring a few exceptions) must consider the pro-rata rule. Each withdrawal (or Roth conversion) will contain a proportionate amount of pre-tax and after-tax dollars. With a 401(k), pro-rata works differently. In-plan Roth conversions can target only the after-tax dollars (and their earnings). In fact, if a 401(k) plan contains after-tax (non-Roth) dollars and the plan participant does a full rollover, the plan can carve off the after-tax dollars and send them in a separate check for deposit into a Roth IRA. This qualifies as a tax-free Roth conversion. Even the taxable earnings on the after-tax (non-Roth) dollars can be separated and lumped into the plan’s pre-tax “bucket” for rollover into a traditional IRA.
The list of differences between IRAs and 401(k) plans goes on and on. Investment options, hardship withdrawals, creditor protection and even basic rules governing access to the dollars are all different. While IRAs and 401(k) plans may seem similar, it is critical to recognize that they operate in two separate and distinct worlds.
By Andy Ives, CFP®, AIF®
IRA Analyst
Ed Slott and Company, LLC
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Christian Cordoba, founder of California Retirement Advisors, has been a member of Ed Slott's Master Elite IRA Advisor Group since 2007.