Anyone looking for the best ways to save for retirement has likely come across 401(k) and IRA options. The question is: what is the difference, and which one is better?
While there are many similarities between these types of accounts (including tax advantages for retirement savings), there are also some key differences to understand and consider before choosing which route to take.
Before we get started, we should note that one is not categorically better than the other. Both offer benefits and both have potential downsides. Your circumstances, priorities, and savings goals will help determine who wins for you in the IRA vs 401(k) battle.
This guide includes helpful information about the similarities and differences between IRAs and 401(k) accounts- plus detailed explanations of how both work and what to expect as an account holder.
Understanding 401(k) and IRA
Let’s begin by looking at each account type and its fundamentals individually. It is impossible to compare options and make the best choice without understanding what they are and how they work.
What Is a 401(k)?
401(k) plans are a way to save for retirement through an employer. They are company-sponsored, not individual retirement accounts. The employee and employer can contribute.
These plans work by taking an agreed percentage of a person’s wage and automatically depositing it into the 401(k) savings account. The employer then also contributes the same or less than that amount (it varies depending on the company and their policies).
There are two types of 401(k) accounts: traditional and Roth. They both work the same as far as contributions are concerned, but the tax advantages are slightly different.
If you have a traditional 401(k), contributions use pre-tax dollars taken from the gross salary. You then pay the delayed income tax when you withdraw. With Roth IRAs, funds are paid from the after-tax salary- meaning there is no tax to pay when you retire and decide to use the money.
In both cases, 401(k) accounts offer tax benefits to those saving for retirement.
Employee Contributions to 401(k)
Employee contributions are paid directly from their salary (pre-tax in traditional 401(k)s and after-tax in Roth 401(k)s) at an agreed rate. You choose what percentage of your income you want to commit to your retirement savings 401(k).
The contribution limits for employees who sign up for a 401(k) are currently $23,000 per year (up from $22,500 in 2023). This applies to those under 50 years old. Once you reach 50, you are allowed to pay an additional $7,500 as a catch-up contribution.
Employer Matching in 401(k)
401(k) accounts let the employer match an employee’s contribution using the formula of their choice. An example could be the employer matching every dollar contributed by the employee with $0.50.
Many companies vary their 401(k) matching contributions depending on the percentage of wage contributed by the employee. They may pledge $0.25 per dollar up to a certain percentage, then increase to $0.50 for those who pay more.
This is all down to the company and what they choose to do. Talk to your employer about 401(k) plans offered and how to get the maximum match amount.
401(k) Withdrawal Rules
Unless you meet certain exceptions stipulated by the IRS, you cannot withdraw funds from a 401(k) until you are 59 and a half years old. While you can make withdrawals before such time, doing so will carry a heavy penalty.
If you take money out of a 401(k) before the required age, you pay an extra 10% on top of the income tax owed (unless you have a Roth 401(k), in which case you only pay the penalty).
Any withdrawals from a traditional 401(k) account are taxed as ordinary income, so whatever tax bracket you fall into at the time will apply.
Withdrawals become mandatory once you reach the age of 73. The minimum distribution amount will be decided based on your total savings and life expectancy (more on that later).
Defining an IRA
Next, let’s look at IRAs. IRA stands for individual retirement account– meaning a retirement savings account that you hold, operate, and contribute to on an individual basis. There are many types of individual retirement accounts- all with slightly different rules.
In any case, you open them by yourself through the provider of your choice. A traditional IRA lets you contribute pre-tax dollars to grow tax-deferred until retirement- with a vast selection of investments available to choose from.
Unlike 401(k) accounts, an IRA is not connected to an employer- unless you work for a small business that opens a SEP IRA or SIMPLE IRA on your behalf. With a traditional or Roth IRA, only the account holder contributes- and they can do so however they choose to, as long as they follow the rules.
IRA Contribution Rules
The exact contribution limits and rules depend on the type of IRA you have. The annual contribution limit of $6500 per Roth IRA contribution rules as well as Traditional IRA. Both have annual contribution limits of $6,500 for those under 50s and $7,500 for account holders aged 50 or older.
You can, however, contribute a lump sum by rolling over an existing retirement savings account into the IRA for whatever reason.
Types of IRAs: Traditional and Roth
When we start examining IRA types in detail, Traditional and Roth IRA come out as highlighted choices of study. Like traditional and Roth 401(k) accounts, the main difference between a traditional IRA and a Roth IRA is when you pay taxes on the contributions.
They follow the same pattern: a traditional IRA contribution is paid before tax to be taxed as ordinary income in retirement, while Roth IRA contributions use after-tax dollars, and there is nothing to pay later.
There are also a few other differences between these IRAs. The most important difference is the required minimum distribution rules. Traditional IRAs have the same rules as 401(k)s, but there are no mandatory withdrawals in retirement from a Roth IRA. This makes them the favored option for wealthy savers who don’t plan on using the funds straight away or intend on leaving the account to heirs as part of their estate.
IRA Withdrawal Guidelines
Waiting until the account holder is 59 and a half years old is advisable when it comes to the withdrawal of IRA funds. Early withdrawals trigger a 10% penalty tax in addition to the regular income tax. Traditional IRAs share the same required minimum distributions as 401(k) accounts, meaning mandatory withdrawals determined by the IRS kick in once the account holder reaches 73. It highlights the significance of understanding IRA withdrawal rules in navigating these processes.
Comparing 401(k) and IRA
Now that we have looked at the different accounts individually- let’s compare the two on a few important points.
The tax implications of 401(k) accounts and IRAs are more or less the same when compared like-for-like (traditional IRA vs 401(k) plans. In both cases, contributions can be made tax-free at the time- letting the contents of the account grow tax-deferred until retirement.
IRA contributions are tax-deductible, and money that goes automatically from a person’s income into their 401(k) reduces their taxable income.
Roth IRAs and 401(k)s work differently from the traditional versions tax-wise. You pay normal income taxes on the funds before they are deposited but get tax-free withdrawals in retirement in return.
Contribution Limits Comparison
The annual contribution limits are one of the main things that set these accounts apart. Traditional and Roth IRAs both have pretty simple limits: $6,500 if you are under 50 and $7,500 if you are over 50.
In comparison, a 401(k) can have up to $23,000 contributed each year for under 50s and up to $30,500 or over 50s once you include the catch-up contribution. This is quite a significant difference no matter what type of IRA you have.
Early Withdrawal Penalties
Early withdrawal rules are the same for 401(k)s and IRAs. Neither accounts allow withdrawals before age 59 and a half without a 10% tax penalty. After this point, you pay income taxes on withdrawals from traditional accounts but nothing on Roth account withdrawals. That applies to IRAs and 401(k) accounts.
The exemptions to this rule are also consistent. Examples of those who can take penalty-free withdrawals before 59 and a half are those with disabilities.
One important difference between these accounts regarding early withdrawals applies to first-time home buyers. IRA holders can take up to $10,000 to put toward the purchase of their first home without paying any penalty, but 401(k) holders have to take out a loan against their savings. This loan must be repaid in full before leaving the job, or you will face a 10% penalty.
Understanding Required Minimum Distributions (RMDs)
Required minimum distribution rules are not so different between IRAs and 401(k) plans, but they do depend on the type of account you have. Roth accounts (IRA and 401(k) have no RMDs, but traditional accounts on both sides kick in once you turn 73.
Weighing the Pros and Cons of 401(k) and IRA
Here is a summary of the pros and cons of both types of accounts. Some apply on both sides, and others are specific to one or the other.
Benefits of 401(k)
- Higher contribution limits
- Lets the employer match contributions at a variable level
- Option to take out a loan against the savings
- Tax-free contributions on traditional accounts and tax-free withdrawals on Roth accounts
- Automatically deducted from your paycheck
- Convenient and easy since most of the setup and admin is handled by the employer
- Exempt from seizure by creditors
- Can be rolled over when you change employer
- Option to buy shares of company stocks
Drawbacks of 401(k)
- Expensive for employers to set up
- Only available as a workplace retirement plan- not individual
- Higher annual fees
- Early withdrawal penalties
- Required minimum distributions on traditional accounts
- Limited investment options compared to IRAs
- Failure to repay the loan results in a tax penalty of 10%
Advantages of IRA
- Huge range of investment options
- Self-directed and entirely under your control
- Funds from other retirement accounts can be rolled over into an IRA (including 401(k))
- Possibility to take $10,000 out penalty-free to buy a first home
- Lower account costs
- Easy to set up and manage
- You (not an employer) pick what financial institution you want to work with
- Tax-free contributions on traditional accounts and tax-free withdrawals on Roth accounts
Limitations of IRA
- Lower annual contribution limits
- Traditional and Roth IRAs do not allow employer contributions
- 10% penalty for early withdrawals
Deciding Between 401(k) and IRA
Situations Favoring a 401(k)
- Your employer offers a plan already.
- You want to save the maximum amount.
- You are happy for your employer to take the lead.
Scenarios for Choosing an IRA
- You do not have a workplace retirement plan.
- You want to save individually outside of work.
- You want more flexibility and control over your money.
Merging 401(k) and IRA: Optimal Benefits
The good news is that you can have both- if your employer offers a 401(k). If this applies to you, merging the two is the best way to get the most out of your retirement account strategy.
Exploring Other IRA Types
SEP IRAs: An Overview
A Simplified Employee Pension IRA helps self-employed individuals and small businesses with retirement. Only the employer can open it, but they must contribute equal percentages for themself and anyone who works for them.
SEP IRAs have an annual limit of $69,000 in 2024- as long as it doesn’t exceed 25% of the person’s wage. Whatever figure is lower is the most that can be contributed annually. Remember, contributions are made by the employer.
Understanding SIMPLE IRAs
SIMPLE IRAs are low-income threshold plans that let employers and employees contribute pre-tax dollars.
Here are some SIMPLE IRA’s key features worth thinking about. Employee contribution limits for are $15,000 (with a $3,500 catch-up contribution allowed for those over 50). Additionally, employers can contribute up to 3% of the employee’s annual contribution.
Investment Strategies for 401(k) and IRA
- Diversification in 401(k) and IRA
Diversify your account as much as possible to hedge against inflation and protect your wealth. Invest in different types of stocks and options- don’t put all your eggs in one basket.
- Managing Investment Risks
Weigh the risks and rewards of the investments you choose for a retirement account. You want the funds to grow- but you also need some level of protection. A mix of risk levels is best.
- Maximizing Employer Match in 401(k)
Look into your employer match policies to find out how to get the most from them.
- IRA Investment Options
IRAs have far more investment options than 401(k)s- including mutual funds, stocks, bonds, and commodities.
Rollover Options: 401(k) to IRA
You can move 401(k) funds into an IRA when you leave an employer. The process is known as a rollover.
Understanding Rollover Process
Direct rollovers or transfers are the safest way to do it. In this case, the transaction is arranged directly between the administrators of both accounts.
Indirect rollovers are where you withdraw funds from your 401(k) and deposit them into the IRA within 60 days. If you do it on time, there is nothing to pay.
Tax Implications of Rollover
Miss the deadline, and you will face the same tax and penalties as an early withdrawal. We are talking about potentially large sums of money, so the tax implications of failing to complete a rollover are significant.
As long as you are moving between two traditional accounts, you don’t need to pay taxes. It is more complicated to move from a Roth to a Traditional account and vice versa, but your account advisor can help you navigate taxable events.
Timing a Rollover
Rollovers are best when you need to consolidate an old 401(k). As long as the whole process is finished within 60 days, it doesn’t matter when you do it.
Frequently Asked Questions
Is a 401(k) considered an IRA for tax purposes?
No, but the tax rules are largely the same for both.
Can you lose money in an IRA?
You can lose money in an IRA- and a 401(k). Whenever money is invested, there is a risk of losses- such is the nature of the stock market.
Can you roll a 401(k) into an IRA penalty-free?
As long as you follow the rules, you don’t need to pay taxes or penalties.
Is it better to max out 401(k) or Roth IRA?
It is generally better to max out Roth IRA contributions before your 401(k). There are income limits on a Roth IRA, but if you are eligible- then maxing out the contributions can offer tax benefits and other advantages in retirement. The withdrawal rules are a bit more relaxed, and there are no RMDs.
401(k) plans have much higher limits, so you should max the Roth IRA first and then contribute as much as you can to the 401(k).
Can I take a loan from my IRA or 401(k)?
You can take a loan from a 401(k) (if the employer allows it) but not an IRA. The loan must be repaid before leaving the job. If not, you pay 10% extra.
One is not better than the other- they are just different. 401(k)s and IRAs are excellent tools for tax-advantaged retirement savings, and it is worth considering both if possible.
It is worth signing up if your employer offers a 401(k) plan- but you may also want to open an IRA for individual saving and investing.