IRA vs. 401(k) // What’s The Difference & How To Choose

You can never start too early when it comes to saving for retirement, but many people find themselves wondering what kind of retirement savings account they should open. They may have access to a 401(k) through their employer, but many people also know about individual retirement accounts (IRAs) as well. So, what is the difference between an IRA and 401k and which one should you choose? The answer depends on your personal 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 toward your retirement plan, then 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 the fact that an IRA is opened by an individual at their own brokerage or bank, while a 401(k) is typically sponsored through your employer. However, do not think that just because you are self-employed that a 401(k) is not an option. Even those who own their own business or are self-employed can still open a solo 401(k) plan. Here are a few quick tips to make choosing between an IRA and 401(k) a little easier.

If you have access to a 401(k), you should probably start by choosing this option first. This is especially true if you have access to an employer-sponsored 401(k). Typically, your employer will provide matching contributions to your account. For example, if you contribute 3% of your salary into your 401(k), then you might get another 3% added by your employer. This is basically free money that you would lose 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 away more money into this account. Since these contributions are tax deductible, this will save you money on your tax bill today and grow your account even larger for your future retirement.

Maybe you find yourself in a situation where you do not have access to a 401(k) plan or you 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 allow you to diversify your tax base as well. 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 general consensus is that you should contribute at least the amount of your employer’s match to your 401(k) first, and then consider opening an IRA next.

As a side note, some employers offer pension plans as well. These plans are typically funded completely by the employer and do not require any contributions from the employee. If you are lucky enough to have a pension, then you should participate in a 401(k) as well. While there is no clear winner between a pension vs a 401(k), you should take advantage of both plans if you have the chance. Pensions are also separate from any IRAs that you might consider opening as well.

How A 401(k) Works

Now we will dive into a little more detail on exactly how a 401(k) plan works. As previously stated, most 401(k)s are sponsored by your employer. In the case where you are both the employer and the employee, you are allowed to open a self-employed or solo 401(k). Your employer will decide exactly how the plan operates within the rules set forth by the IRS. For example, your plan may or may not allow loans. Your plan administrator will also determine which types of investments are available in your plan. Generally, you have access to stocks, mutual funds, bonds, and other publicly traded securities.

In some cases, you may be automatically enrolled in your employer’s 401(k) when you begin work. You make contributions to the plan on a pre-tax basis. This means that the money is automatically withheld from your paycheck and placed into the account. Your employer might also match the funds that you place into the account. There is usually a limit on the employer match, and that amount is typically anywhere from 2%-4% of your salary. Since you are using pre-tax dollars to fund the account, this means that your taxable income in the current year is lower. In 2021, you are allowed to contribute up to $19,500 into your 401(k).

The investments in your account are allowed to grow tax-free until you reach retirement age. Upon reaching age 59 1/2, you are free to withdraw funds from your account for retirement. Since no taxes have been paid on the funds in your account, you will pay regular income tax on the funds when they are withdrawn. If you hold employee stock in your account, you might also save some money by paying long term capital gains tax instead of normal income tax on your withdrawal.

Should you need access to the funds in your account before age 59 1/2, you will pay those taxes plus an extra 10% early withdrawal penalty. There are a few exceptions to this penalty, so be aware that in some cases you can make a 401(k) withdrawal without a penalty. You should also note that once you reach age 72, you will be forced to take required minimum distributions (RMDs) from your plan. This will increase your taxable income during those years and might put you in a higher tax bracket.

If you change employers, you can perform a rollover of your 401(k). This means that you take the money that is in your account from your previous employer and roll it over into an account with your new employer. In some cases, you even have an option to roll the funds over into an IRA. When you perform this type of rollover, there are no taxes or penalties associated with that transaction. Some employers might even allow you access to a Roth 401(k). This type of account allows you to contribute after-tax dollars. This means that your withdrawals will be tax-free, although not all employers offer this kind of plan because they can be difficult to manage.

If you have a 401(k) and you die, then your plan allows you to have a named beneficiary to receive the money in your account. The 10% tax penalty is generally waived if your beneficiary decides to cash out the balance, even if they are under age 59 1/2. If the plan belonged to your spouse, you might also qualify for Social Security spousal benefits or survivors benefits. If you think you might qualify for those, then you should go ahead and apply for benefits. You may be entitled to up to 100% of your spouse’s benefit amount. Failure to claim those benefits could result in a large loss of money that you could be receiving.

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 when it comes to investment options. Not only can you choose to invest in traditional stocks, bonds, and mutual funds, but you also have many other options. 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 usually not available for investment through a 401(k) plan.

The funds that you place into a traditional IRA are tax deductible for the year in which you make the contribution. This helps with your tax bill in the current year, but really 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 it does allow you to take withdrawals that are tax-free. There are income limits to Roth IRA eligibility, 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 2021, you can only contribute $6,000 per year to an IRA. If you are over age 50, then you are allowed to contribute an extra $1,000 in catch up contributions for a maximum of $7,000 during the year.

When it comes time for retirement, an IRA functions much the same way as a 401(k). 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 does allow you to take a withdrawal from your account without paying the 10% penalty. Another benefit of an IRA is the fact that there are no required 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.

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. The differences between these types of accounts are very similar when discussing a Roth 401k vs IRA. 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.

While we are on the topic of contributions, the contribution limits between these two types of accounts vary drastically. In 2021, you can contribute up to $19,500 into your 401(k) or up to $26,000 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 $58,000 per year in contributions to your 401(k) and up to $64,500 for those age 50 and older. Compare that to the limit of $6,000 per year for an IRA or just $7,000 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.

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. 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.

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.

Key Differences – IRA vs 401k
IRA 401k
Contribution Limits (2021) $6,000 ($7,000 if age 50 or older) $19,500 ($26,000 if age 50 or older)
Withdrawal Rules Must wait until age 59 1/2 to avoid 10% early withdrawal penalty.
No minimum distributions required.
Must wait until age 59 1/2 to avoid 10% early withdrawal penalty.
Required minimum distributions beginning at age 72.
Advantages Wide range of investment options
Contributions may be tax deductible
Low fees
High contribution limits
Employer match equals free money
Disadvantages Lower contribution limits
Contributions may not be tax deductible for higher income individuals
Fewer investment choices
Higher maintenance and management fees

What To Do If Your Employer Offers A 401(k) Match

If your employer offers a 401(k) match, then you should definitely take advantage of it! You are basically losing out on free money if you fail to take advantage of the matching funds. At the very least, you should contribute enough money to your 401(k) to take advantage of the full 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 up to your employer match because this match is basically a guaranteed return on your money.

Once you have maxed out your 401(k) contribution, then 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. If you are already participating in your employer-sponsored 401(k), then make sure you keep an eye on the IRA tax rules. 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. Your financial advisor should be able to assist if you have any questions about the IRA contribution limits and their tax deductibility.

Finally, you should revisit your 401(k) and make additional contributions there. 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 for maximum diversification of your funds, and allows you to 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, then it usually makes sense to go ahead and contribute to an IRA first. You will not be losing out on any free money since you will not be receiving any employer contributions anyway. Since an IRA offers more investment options and generally lower fees, you should go ahead and max out your contributions to this account before putting anything into 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 fairly quickly since the annual contribution limit on an IRA is only $6,000.

Once you hit that limit, then you can look toward 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 $19,500 into your 401(k) per year. So, as you can see, the 401(k) contribution limits are quite high. Even if you are unable to 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 be in a situation where you do not even have access to an employer-sponsored 401(k) at all. If you are a business owner, freelancer, contractor or other self-employed individual, then you should go ahead and open a solo 401(k) account. As long as your business has no other employees, then you can open this account and begin making contributions. Going this route will maximize the amount of money that you are allowed to put away. Since you are both the employer and employee, you can contribute all the way up to $58,000 into your 401(k) when you take into account the employer contributions as well. You will also get a big break when it is time to file your tax return as well 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), then you should go ahead and open an IRA. It is likely that you will 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.

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 major differences in the details. There are big differences in the contribution limits between the accounts and required distributions. You will also see differences in the investment options and fees associated with the accounts. When it comes time to choose, make sure that you have all the information you need to make the best decision for your situation. Choosing the wrong type of account could cost you thousands of dollars in lost employer matches or extra taxes. If you are unable to make the decision on your own, then your financial planner can help steer you in the right direction.

Frequently Asked Questions

What are the disadvantages of an IRA?

While an IRA does offer many advantages, there are also some cons associated with this kind of brokerage account. First, the IRA contribution limits are quite low. You can only contribute $6,000 per year ($7,000 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 on your taxes if your income is too high. Similarly, you might not be allowed to contribute to a Roth IRA at all if your income is above the limit.

Can you lose money in an IRA?

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 that you choose, your risk associated with the account may be higher or lower. If you have less appetite for risk, then you should choose investments that are generally safer in nature. 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 as well. You should generally attempt to diversify your portfolio and invest in a combination of low risk and higher risk items. This will balance the potential for higher returns with more stable investments that are not as likely to lose value.

Which is a better investment for retirement?

It is hard to say which investment is better for retirement. The answer to this question will depend on what options are available to you and what your personal financial situation is. Both can be great avenues for saving money for retirement. A 401(k) is going to allow you to make more contributions each year than an IRA. However, an IRA generally has lower expenses and fees. If you have access to an employer match with your 401(k), then you should go ahead and contribute to the 401(k) first. Contribute at least enough to max out your employer match. Once you are making those contributions to your 401(k), then you should go ahead and consider opening an IRA. Just be aware that you might not be able to deduct all your IRA contributions from your current taxes if your income is too high and you participate in a 401(k).

What is the difference between a traditional IRA and a Roth IRA?

The main difference between a traditional and 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 rather will pay taxes on them when you make withdrawals. With a Roth account, you pay taxes on the dollars today like normal income. When you withdraw those contributions, you get to enjoy them tax-free in retirement. There are also eligibility differences between the two types of accounts. If your income is too high, you will not be allowed to 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 if you can contribute to both plans.

How do I open a 401(k)?

In many cases, your 401(k) account will be opened automatically upon starting employment. In other cases, you might have to opt in to your employer’s plan. Simply contact your Human Resources department, and they can guide you on the proper steps to get your account opened. Once your account is established, you can decide how much money to contribute and which investments to select. The money will be automatically withdrawn from your paycheck, so making the contributions is easy on your part.

How do I open an IRA?

Opening an IRA requires a little more work on your part. You will need to visit your local bank or brokerage firm. Many online brokerage firms allow you to open an IRA easily. You will simply need to decide how much money you will be placing into the IRA and make your investment selections. Once opened, you will receive regular statements to show how your investments are performing. You can deposit additional funds on any schedule you choose up to the maximum contribution amounts each year.

Elliot Marks

Elliot Marks

Author & Social Security Advisor

Elliot Marks has spent over 10 years providing clear and concise information to help Americans navigate the complex nuances of social security and many other government services in the United States. Elliot has a passion for helping those in need of these services to be able to find timely access to news and information that is relevant and helpful to their daily lives.