In a Nutshell
When deciding on a retirement account, your options may include an IRA or a 401(k). A 401(k) is an employer-sponsored retirement account and an IRA is an individual retirement account. The two accounts offer different contribution, distribution and deduction guidelines.If you want to get tax benefits on your retirement savings, an individual retirement arrangement account or 401(k) are solid choices, each coming with tax advantages. The main difference between an IRA and a 401(k) is that an employer must set up a 401(k). In contrast, individuals set up their own IRAs.
Deciding which investment vehicle to use takes time and careful planning. To help you choose the option that works best for you, we’ll review the differences between IRAs and 401(k)s.
Differences between traditional 40(k)s, Roth 401(k)s, traditional IRAs, Roth IRAs and SEP IRAs
| Traditional 401(k) | Roth 401(k) | Traditional IRA | Roth IRA | SEP IRA | |
|---|---|---|---|---|---|
| Contribution limit (2023) | $22,500 | $22,500 | $6,500 | $6,500 | $66,000 |
| Catch-up contribution | $7,500 | $7,500 | $1,000 | $1,000 | none |
| Employer match | Yes | Yes | No | No | No |
| Contributions before or after taxes | Pre-tax dollars | After-tax dollars | Pre-tax or after-tax dollars | After-tax dollars | Pre-tax dollars |
| Investment selection | Small, in employer’s control | Small, in employer’s control | Large, in your control | Large, in your control | Large, in your control |
| Penalties for withdrawal before age 59 and a half | Yes | Yes | Yes | Yes | Yes |
IRAs
An individual retirement arrangement (or IRA) is a retirement savings account set up by an individual rather than an employer. If you have a Roth IRA, you’ll pay taxes on money going into your account. But if you have a traditional IRA and don’t pay taxes upfront, you’ll be charged on the back end.
Unlike 401(k)s, IRAs give account holders a wider array of investment options. You can place different assets within your account, such as …
- Stocks
- Bonds
- ETFs
- CDs
Traditional IRA
A traditional IRA allows for a tax deduction on your contributions. But you’ll pay taxes when you take money out of your account in retirement.
Pro: A traditional IRA lets you contribute pre-tax or after-tax dollars. You can also claim a deduction on contributions.
Con: Compared to a 401(k), traditional and Roth IRAs have lower contribution limits. With some exceptions, you will also face penalties for withdrawals made before age 59 and a half.
Roth IRA
A Roth IRA doesn’t allow you to deduct your contributions. However, since your account funds draw from after-tax dollars, you won’t pay taxes on your investments or gains when you withdraw in the future. For this tax benefit to kick in, you need to meet the age distribution requirements and hold your account for over five years.
Pro: Unlike a traditional IRA, you can make penalty-free withdrawals after five years. You also contribute after-tax dollars, so you won’t pay taxes after making a withdrawal.
Con: Roth IRAs don’t offer current-year tax deductions on contributions.
SEP IRA
If you’re self-employed or own a small business, a simplified employee pension (or SEP) IRA may suit you. This retirement account offers tax breaks for self-employed individuals and business owners to save for the future.
Pro: SEP IRAs offer higher contribution limits than traditional or Roth IRAs.
Con: SEP IRAs don’t allow catch-up contributions. Additionally, all withdrawals face income tax.
401(k)s
A 401(k) is a tax-deferred retirement savings account that an employer sets up. Because this is a company-controlled investment, you have a smaller investment selection than you would with an IRA. However, a 401(k) typically offers an employer match, meaning your employer will add to your retirement contribution.
In a traditional 401(k), you’ll invest pre-tax dollars, meaning you can reduce your taxable income as you invest. Typically, you should avoid cashing out your 401(k) before retirement because early withdrawals result in penalties. The best way to get the most out of your 401(k) is to keep your money in the account at least until age 59 and a half.
Image: 401k-typesTax-deferred (traditional) 401(k)
A tax-deferred 401(k) allows you to save taxes today and save for retirement. Workers set aside a portion of their pay before federal and state income tax withholdings apply. This lets employees lower their taxable income and pay less income tax.
Pro: 401(k)s offer higher contribution limits than most IRAs and may come with a company match. You may be able to take a loan out against the account without facing tax penalties.
Con: Without careful planning, you will owe taxes after withdrawing from a 401(k). Additionally, your employer has more control over the assets in the account.
Roth 401(k)
In a Roth 401(k) you pay taxes as you contribute and won’t have to pay taxes when you withdraw your investment. Unlike a Roth IRA, you can’t make withdrawals at your discretion. For qualified distributions that avoid tax penalties, you must meet the following criteria:
- The account has been held for over five years
- The account holder is over age 59 and a half, or the withdrawal is due to the holder’s disability or death
Pro: Roth 401(k)s allow you to square away tax payments before you withdraw.
Con: Withdrawing before age 59 and a half isn’t possible unless you meet specific IRS criteria.
Differences between an IRA and 401(k)
It’s essential to know each difference between an IRA and a 401(k) so you can make an informed decision about which is right for you. You should also consider making a financial plan that outlines which type of retirement investment accounts you’ll use to stay on top of your savings.
To help you do that, we’ll explain a few categorical differences between an IRA and 401(k).
Account type and availability
A 401(k) is an employer retirement account and an IRA is an individual retirement account. As a result, You can only enroll in a 401(k) if your company offers one. On the other hand, anyone who earns income in a given year can contribute to an IRA.
You can open an IRA through any of the following:
- Brokerage company
- Bank
- Investment firm
- Insurance company
Investment options
401(k)s offer a limited selection of investment options built into the plan by the employer. Typically, these include bond funds and stock funds. IRAs provide a wider array of investment options, such as individual stocks and bonds, mutual funds, CDs and ETFs.
Contribution limits
The Internal Revenue Service sets 401(k) and IRA contribution limits each year. 401(k)s tend to offer higher limits and may come with a company match. If you’re over 50 years old, the IRS lets you make an additional catch-up contribution. Below are the 2023 limits.
- IRA holders below 50 — $6,500
- IRA holders 50 and older — $7,500
- 401(k) holders below 50 — $22,500
- 401(k) holders 50 and older — $30,000
Tip: If your company offers a 401(k) with a company match, you should consider setting up your 401(k) and contribute the total match amount.
Account security
401(k)s provide more security from creditors in the case of a lawsuit or bankruptcy. This is because a 401(k) is a protected federal account immune to creditors.
On the other hand, creditors are free to garnish your IRA unless you declare bankruptcy. In this case, the government will protect up to $1,512,350 from creditors between traditional, Roth and SEP IRA accounts.
Tax deductions
Contributions to retirement accounts can offer tax benefits. That said, different accounts come with their own restrictions. The rules for deductions include the following:
- Traditional 401(k) — While contributions don’t offer a tax deduction, they reduce your gross income and lower tax liability.
- Roth 401(k) — Because your contributions are made after taxes, you pay taxes as you contribute. Earnings from the account aren’t taxed when you withdraw.
- Traditional IRA — If your income exceeds certain levels and you have a retirement plan at work, the IRS may limit your tax deduction.
- Roth IRA — Contributions aren’t deductible.
Distributions
Starting six months before you turn 60, you can take penalty-free withdrawals from either type of account. Before that, distributions from these accounts may result in additional taxes or penalties. There are a few ways to avoid this.
- You may be able to take a loan against your 401(k) to avoid these penalties.
- You can withdraw from a Roth IRA as much as you like after it’s open for five years. This allows it to double as an emergency fund.
Note: You must take distributions from your 401(k) and traditional IRAs by age 72.
IRA vs. 401(k) FAQs
If you’re still wondering which retirement savings account is best for you, we’ve got you covered with these frequently asked questions and answers.
Should I take advantage of my company’s 401(k)?
If your company offers a 401(k) with a company match, you may want to consider setting up your 401(k) and contributing the match amount if you can afford it. Why? It’s free money that your employer is giving you for retirement, so you may as well take advantage of it.
Just make sure you avoid the common investing mistake of counting your employer’s match toward your maximum contribution. Instead, your maximum contribution refers to the amount of money you put in by yourself.
What if I have leftover funds to invest after the 401(k) match?
Once you’ve met your company’s 401(k) match, you can look at IRA options to diversify your investment portfolio. Having multiple retirement savings accounts isn’t for everyone, though.
If the thought of having two is overwhelming, you can stick to the 401(k) and contribute more than your company match, although there are 401(k) contribution limits.
How do I decide which IRA to open?
If you decide to diversify your investments, you’ll need to decide which IRA you’d like to open. Remember that your Roth IRA will be funded with after-tax dollars. But you won’t pay any taxes when you withdraw your funds in retirement.
Since your traditional IRA functions more similarly to a 401(k), you can reduce your taxable income today. Still, you’ll pay taxes on your investment and gains in the future.
Can you have an IRA and a 401(k)
Both 401(k)s and IRAs are essential investment accounts you should consider when preparing for retirement. As a result, you may ask: “Can I contribute to a 401(k) and IRA?” While you don’t need to have both, it’s an option. While having both an IRA and a 401(k) might seem overwhelming, it can be beneficial.
Using both retirement accounts can help you.
- Maximize your savings
- Take all possible tax advantages
- Diversify your investment portfolio
- Grow your overall earnings
If you’re starting to invest, keep in mind that it might be better to start with one account. That way, you can learn how these accounts work before you take on both.
Start saving for the future
In addition to having retirement accounts, having a high savings rate — essentially, how much money you save each month compared to your gross income — can also be highly beneficial. The challenge in getting started lies at the beginning with an IRA vs. 401(k). Retirement accounts can play a key role in saving for the future. With a better understanding of an IRA vs. 401(k), you can make sound investments that pay off throughout your retirement. And with our 401(k) calculator, you can find out just how much you may need.
Sourcing
- Definition of an IRA. Topic No. 451 Individual Retirement Arrangements (IRAs) (February 2023)
- SEP IRA information. Simplified Employee Pension Plan (SEP) (December 2022)
- Definition of a 401(k). 401(k) Plan Overview (November 2022)
- Description of a Roth 401(k). Retirement Plans FAQs on Designated Roth Accounts (November 2022)
- Cons of withdrawing retirements fund before age 59. Considering an early retirement withdrawal? CARES Act rules and what you should know (June 2022)
- 401(k) and IRA contribution limit. 401(k) limit increases to $22,500 for 2023, IRA limit rises to $6,500 (December 2022)
- Information about ERISA-protected retirement accounts. FAQs about Retirement Plans and ERISA (March 2023)
- IRA creditor protection. April 1 Increase of Federal Bankruptcy Exemptions, Other Dollar Amounts (March 2022)
- Comparison between Roth retirement accounts. Roth comparison chart (November 2022)
- IRA tax deduction limits and considerations. IRA deduction limits (October 2022)
- Information on Roth IRA accounts. Roth IRAs (October 2022)
- Information on early distribution tax penalties. Retirement Topics – Exceptions to Tax on Early Distributions (September 2022)
- Retirement distribution deadline. Retirement Plan and IRA Required Minimum Distributions FAQs (March 2023)
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