You can never start too early when it comes to retirement savings, but many people wonder what kind of retirement savings account they should open.
They may have access to a 401(k) through their employer, but many know about individual retirement accounts (IRAs). So, what is the difference between an IRA and 401(k), and which one should you choose?
The answer depends on your situation. Both offer some tax advantages, although the timing of those advantages can differ depending on which type of account you open.
If you are ready to start contributing to your retirement plan, keep reading! We will tell you everything you need to know about IRAs and 401(k)s so that you can choose the best option for your financial situation.
IRA vs. 401(k): The Short Version
One of the first considerations when choosing between these two accounts is that an individual opens an IRA at their brokerage or bank. At the same time, a 401(k) is typically sponsored through your employer.
However, do not think that a 401(k) is not an option just because you are self-employed. Even those who own their own business or are self-employed can open a solo 401(k) plan.
Here are a few quick tips to help you decide between an IRA and a 401(k).
If you have access to a 401(k), you should probably choose this option first. This is especially true if you can access an employer-sponsored 401(k).
- Typically, your employer will provide matching contributions to your account.
For example, if you contribute 3% of your salary to your 401(k), you might get another 3% added by your employer. You would forego this free money if you do not contribute to the 401(k).
- Next, the contribution limits for a 401(k) are much higher than those of an IRA.
So you will be able to put more money into this account. Since these contributions are tax-deductible, this will save you money on your current tax bill and grow your account without owing taxes until a future date.
Maybe you find yourself in a situation where you do not have access to a 401(k) plan or are already making the maximum contribution. In that case, go ahead and consider opening up an IRA.
- Participating in both plans is even better than choosing just one, and it can also allow you to diversify your tax base.
While traditional IRA contributions are tax deductible in the current year, just like a 401(k), you could contribute to a Roth IRA with after-tax dollars.
- This would allow you to make tax-free withdrawals at retirement age.
So, the consensus is that you should first contribute at least the amount of your employer’s match to your 401(k) and then consider opening a Roth IRA.
Side Note:
Some employers also offer pension plans. These plans are typically funded entirely by the employer and do not require contributions from the employee.
If you are lucky enough to have a pension, you should also participate in a 401(k). While there is no clear winner between a pension and a 401(k), you should take advantage of both plans if possible. Pensions are also separate from any IRAs you might consider opening.
KEY TAKEAWAYS
- You can simultaneously contribute to a 401(k) and IRA. A great option is first contributing at least the amount of your employer’s match to our 401(k) and then maxing out your contribution to a Roth IRA.
- The contribution limits are much higher for a 401(k) than an IRA. Plus, a 401(k) allows you to make pre-tax contributions even if you are a high-income earner. Pre-tax contributions to an IRA phase out at higher income levels.
- Contributions made to either a 401(k) or IRA on a pre-tax basis will be taxed upon withdrawal of funds. Contributions to a Roth IRA or Roth 401(k) and any gains will not be taxed upon withdrawal.
How Does A 401(k) Work
The 401(k) plan is probably one of the most common retirement accounts in the private sector. It functions very similarly to a 403(b) plan.
These accounts are considered defined contribution plans, and according to the IRS, they are also qualified retirement plans because they are protected by the Employee Retirement Income Security Act (ERISA).
- Employees can make tax-deferred contributions to the plan, and these savings are allowed to grow tax-free in the plan until retirement age.
- An employee may make elective deferrals of up to $23,000 per year into his or her 401(k) with additional catch-up contributions of $7,500 per year after age 50.
- The employer match is a big plus for the 401(k), as many for-profit companies offer matching funds to help their employees grow their retirement savings. This normally ranges between 2% and 4% of your salary.
- If you need to withdraw money from your 401(k) before age 59 1/2, you can expect to pay an early withdrawal penalty. The standard 10% penalty will apply in this case.
- Taxes are due upon withdrawal of any tax-deferred 401(k) plans.
- If you change employers, you can perform a rollover of your 401(k). You can transfer the funds into an IRA or 401(k) account with your new employer.
- Some employers might offer a Roth 401(k) option. This allows you to contribute after-tax dollars and enjoy tax-free distributions in retirement on the contributions and gains.
- Most 401(k) plans have a vesting period. You might lose some of your employer’s matching funds if you leave the company before fully vested in the plan. This period can range from a few months to a couple of years.
- Some 401(k) plans allow for loans without penalty, although you should check your plan documentation for specifics. Upon reaching age 73, you will be forced to take the required minimum distributions (RMDs) from your account.
How An IRA Works
As the name implies, these accounts are opened by individuals and are not sponsored through an employer. To open this account, you simply contact your bank or brokerage firm.
- These accounts offer a great deal of flexibility regarding investment options.
You can invest in traditional stocks, bonds, and mutual funds, but you also have many other options. For example, you might choose to invest your IRA funds in real estate, gold coins, silver, ETFs, or some type of commodity.
Many of these options are unavailable for investment through a 401(k) plan.
- The funds you place into a Traditional IRA are tax deductible for the year you contribute.
This helps with your tax bill in the current year but just delays payment of the taxes until you make a withdrawal.
- If you choose to invest in a Roth IRA, then you will contribute after-tax dollars.
This does not provide any current-year tax benefits but allows you to take tax-free withdrawals.
- Roth IRA eligibility has income limits, so if your income is too high, you will not be able to contribute to a Roth account.
While discussing contributions, it should also be noted that the contribution limits for an IRA are somewhat low.
- In 2024, you can only contribute $7,000 annually to an IRA. If you are over age 50, you can contribute an extra $1,000 in catch-up contributions for a maximum of $8,000 during the year.
An IRA functions much like a 401(k) in terms of retirement. You cannot withdraw funds from your IRA before age 59 1/2 without incurring an early withdrawal penalty unless you have elected to use a Roth IRA.
- In certain hardship situations, the IRS allows you to withdraw from your account without paying the 10% penalty.
Another benefit of an IRA is that certain IRA accounts do not require minimum distributions for the account owner. You can keep the money in the account as long as you wish without being required to withdraw any of it. However, your beneficiaries will be subject to RMDs.
Must read articles related to Retirement
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What To Do If Your Employer Offers A 401(k) Match
If your employer offers a 401(k) match, you should use it! You are losing out on free money if you fail to use the matching funds.
- At the very least, you should contribute enough money to your 401(k) to take advantage of the entire match provided by your employer. Even if your 401(k) has higher fees than you might expect, it still makes sense to contribute at least the amount to ensure you capture the employer match because this match is a guaranteed return on your money.
Once you have maxed out your 401(k) contribution, you should consider opening a traditional or Roth IRA account.
- The main difference between these types of IRAs is the tax treatment. With a Traditional account, you get the tax break today, while a Roth account provides the benefits when you start making withdrawals.
Watch the IRA tax rules if you already participate in your employer-sponsored 401(k). You might not be able to deduct all your contributions to your traditional IRA, and you might not be able to make contributions to a Roth account at all.
If you have any questions about the IRA contribution limits and their tax deductibility, your financial advisor should be able to assist you.
- Finally, once you max out your IRA, you should revisit your 401(k) and make additional contributions. Since this account has much higher contribution limits than an IRA, you can continue to put more money there without as much danger of hitting the limit.
This overall strategy allows maximum diversification of your funds and lets you put away the most money possible for your retirement.
What To Do If Your Employer Doesn’t Offer A 401(k) Match
If your employer does not offer a 401(k) match, it usually makes sense to contribute to an IRA first.
You will not be losing out on any free money since you will not be receiving any employer match contributions anyway.
- Since an IRA offers more investment options and generally lower fees, you should max out your contributions to this account before contributing to your 401(k).
You can even shop around for investment funds that offer lower fees and make that part of your investment decision. Remember that you will hit your limit on contributions reasonably quickly since the annual contribution limit on an IRA is only $7,000.
Once you hit that limit, you can consider your 401(k) for additional retirement planning. Even though you do not receive an employer match, your 401(k) will allow you to put away a lot of money for retirement and enjoy tax benefits at the same time.
- You can contribute up to $23,000 into your 401(k) per year. So, as you can see, the 401(k) contribution limits are pretty high.
Even if you cannot deduct your contributions into your IRA due to the income limits, your investments will still grow tax-free until you are ready to begin taking withdrawals.
What To Do If You Are Self-Employed
In some cases, you might not even have access to an employer-sponsored 401(k).
- If you are a business owner, freelancer, contractor, or other self-employed individual, you should consider opening a solo 401(k) account. If your business has no other employees, you can open this account and begin making contributions.
Going this route will maximize the amount of money you can put away. Since you are both the employer and employee, you can contribute up to $69,000 into your 401(k) when considering employer contributions.
- You will also get a big break when it is time to file your tax return because your contributions are tax-deferred and will not be considered taxable income in the current year.
Once you have maxed out your solo 401(k), you should open an IRA. You will likely be unable to deduct your contributions if you make enough money to max out your 401(k), but your investments in the account still grow tax-free.
You can also avoid the tax penalty by waiting until age 59 1/2 to withdraw money from the account.
TIP
If you are self-employed and do not have employees, a Solo 401(k) is an excellent option for bolstering your retirement savings. You can contribute a large sum of money to the account annually. Plus, there are options for a Roth 401k and/or traditional 401k.
Key Differences Between A 401(k) And An IRA
Many people ask, “Is a 401k an IRA?” The answer is no. Here we will outline some of the key differences between a 401(k) and an IRA.
For the purposes of this section, we will assume a Traditional IRA vs 401k. You may be interested in learning the differenced between a Roth IRA and a Traditional IRA, but that isn’t covered in this section.
One of the first differences between these accounts is the way that the account is opened.
- A 401(k) is generally opened through your employer, while an IRA must be opened on your own at your bank.
- Funding into an IRA comes completely from your own pocket, while you often receive matching funds into your 401(k) from your employer.
Contributions
While we are on the topic of contributions, the contribution limits between these two types of accounts vary drastically. In 2024, you can contribute up to $23,000 into your 401(k) or up to $30,500 if you are age 50 or older. When you include the allowable employer match of up to 25% of your ordinary income, you are allowed up to $69,000 per year in contributions to your 401(k) and up to $76,500 for those age 50 and older.
Compare that to the limit of $7,000 per year for an IRA or just $8,000 for those age 50 and older. You can quickly see that a 401(k) allows you to grow your retirement savings much faster than an IRA account does as well as take a much larger tax deduction in the current year.
Investment Options
When making your investment choices, you will have many more options available through an IRA.
Your choices in a 401(k) are limited to the funds that your plan administrator has approved. However, with an IRA, your options are almost unlimited. You can choose to invest in a number of different things including some non-traditional options like real estate, gold, silver, and others.
Fees
The fees to manage an IRA are typically lower than 401(k) management fees as well. This can save you some money over the long run as you typically leave funds in these accounts for many years.
Distributions
Lastly, we will take a look at how these accounts vary when it comes time for distributions. With both accounts, you can begin taking distributions penalty-free at age 59 1/2. With an IRA, there are never any required minimum distributions for the account owner. However, with a 401(k), you must begin taking those required distributions upon reaching age 72. This can have some unintended tax consequences, so make sure that you are aware of this situation and discuss it with your tax professional.
| Provisions | 401(k) Plan | IRA Plan |
|---|---|---|
|
Eligibility |
Any employer can sponsor these plans. Employers are are limited on the restrictions that can be placed on participation. |
Any individuals with taxable income can contribute to an IRA. |
|
Contribution Limits |
Employees may contribution $23,000 annually |
Individuals may contribution $7,000 annually |
|
Catch-Up Contributions |
If employee is over 50, an additional $7,500 can be contributed annually. |
If employee is over 50, an additional $1,000 can be contributed annually.
|
|
Tax Implications |
Employee and employer contributions are tax-deferred (unless Roth option is selected).
Employer contributions are deductible for employer. |
Individual contributions are tax-deferred (unless Roth option is selected).
If household income exceeds the IRS income limits, then contributions may only be made on an after-tax basis. |
|
Investment Options |
A comprehensive range of options, such as stocks, bonds, index funds, ETFs, etc.
Chooses are limited by plan documents. |
A comprehensive range of options, such as stocks, bonds, index funds, ETFs, et.
Very few limitation on investment choices. |
|
Withdrawal Rules |
Must wait until age 59 1/2 to avoid 10% early withdrawal penalty.
Required minimum distributions beginning at age 73. |
Must wait until age 59 1/2 to avoid 10% early withdrawal penalty.
No minimum distributions required. |
|
Advantages |
High contribution limits
Employer matches equals free money |
Contributions may be tax deductible
Contributions to a Roth IRA grow tax-free Low Fees |
|
Disadvantages |
Higher maintenance and management fees
Fewer investment choices |
Lower contribution limits
Contribution may not be tax deductible for higher income individuals |
The Bottom Line
IRAs and 401(k)s are two of the most common methods available to save for your retirement. They both offer the ability to make tax-deductible contributions and allow your investments to grow tax-free until you reach retirement age and begin to make withdrawals.
The tax rate you pay then depends on your adjusted gross income at retirement. Though these two accounts are similar in their objectives, there are some significant differences in the details.
The contribution limits and required distributions of the accounts differ greatly. The investment options and fees associated with the accounts also differ.
When choosing, ensure you have all the information you need to make the best decision. Choosing the wrong type of account could cost you thousands of dollars in lost employer matches or extra taxes.
If you cannot decide on your own, your financial planner can help you make the right decision.
Frequently Asked Questions
While an IRA offers many advantages, some cons are also associated with this kind of brokerage account.
First, the IRA contribution limits are pretty low. You can only contribute $7,000 per year ($8,000 if you are age 50 or older) into an IRA.
It is hard to build a large nest egg given this low limit on contributions.
Next, you might be unable to deduct your contributions from your taxes if your income is too high.
Similarly, if your income is above the limit, you might not be allowed to contribute to a Roth IRA at all.
Unfortunately, yes, you can lose money in an IRA. Since an IRA is an investment account, you might experience highs and lows based on market volatility.
Depending on the types of investments you choose, the risk associated with the account may be higher or lower. If you have a lower appetite for risk, you should select safer investments.
However, these investments typically have lower returns as well. If you choose high-risk investments, you might see a great return on those funds, but you could also lose a lot of money.
You should attempt to diversify your portfolio and invest in a combination of low-risk and high-risk items. This will balance the potential for higher returns with more stable investments that are less likely to lose value.
The main difference between a Traditional and a Roth IRA is the timing of the tax benefits.
- With a traditional account, you make tax-deferred contributions. This means that you will not pay income tax on those dollars today but will pay taxes on them (plus any gains) when you withdraw.
- With a Roth account, you pay taxes on the dollars today like normal income. When you withdraw those contributions (and gains), you enjoy them tax-free in retirement.
There are also eligibility differences between the two types of accounts. If your income is too high, you cannot make Roth contributions. At that level of income, you can still make contributions to a traditional IRA, but your contributions may not be tax deductible.
When considering a 401k vs Roth IRA, it is best to contribute to both plans.
Opening an IRA requires a little more work on your part. You will need to visit your local bank or brokerage firm or you can use an online brokerage firms, which make it easy to open an IRA online.
You must decide how much money you will place into the IRA and make your investment selections.
Once opened, you will receive regular statements showing your investments’ performance. You can deposit additional funds up to the maximum yearly contribution amounts on any schedule.
Your 401(k) account will often be opened automatically upon starting employment. In other cases, you might have to opt into your employer’s plan.
Simply contact your Human Resources department, and they can guide you through the proper steps to open your account.
Once your account is established, you can decide how much money to contribute and which investments to select. The funds will be automatically withdrawn from your paycheck, making contributing easy.
You can find a Social Security Administration office near you by using our SSA office locator and searching for your closest location.
