What’s The Difference Between An IRA VS A 401(k)?
Whether you're determining which type of retirement savings account to use or deciding between a Roth 401(k) vs Roth IRA, this guide can help you make the best financial decisions for your future.
Retirement and savings plans are always on individuals’ minds, especially in times of economic uncertainty. Two of the most popular types of these plans are IRAs and 401(k)s. But what is the difference between an IRA vs a 401(k) and is one more beneficial than the other? While they are similar, it’s important not to simply assume that they will yield the same results.
In this post, we will lay out the distinctions between a Roth and Traditional IRA vs a 401(k) in simple terms and give you a better understanding of when (and if) you should think about creating one. We will also discuss which one would be better for your current financial situation.
IRA VS 401(k) The Quick Overview
The most significant difference between an IRA and a 401(k) is that an IRA (individual retirement account) is set up by an individual, whereas a 401(k) is set up through an employer. Both offer benefits, but your place of work must offer a 401(k) as a benefit in order for you to take advantage of it. Some employers also offer a matching option where they will contribute to your plan, up to a specified amount.
The second main difference between the two retirement accounts is that, with an IRA, you can manage your own investments depending on what the brokerage firm your account is through offers. With a 401(k), your money is managed by a third-party decided by your employer.
Both plans offer the option to open pre-tax plans or Roth post-tax plans but have varying limits as to how much you can contribute during a given year. There are other, slight differences between individual IRAs and 401(k) accounts as well that we will get into later in the post.
Table of Contents
What Is An IRA Account?
An IRA (individual retirement account) is a retirement savings account that you can set up on your own, separate from your employer. You can contribute to the account either with pre-tax funds (a traditional account) or post-tax funds (a Roth account).
The Advantages Of An IRA Account
- Simple to set up
- Flexibility in investing
- Insured by FDIC
- Earnings are tax-deferred
- Ownership of your account
The Disadvantages Of An IRA Account
- Penalties for withdrawals
- Roth contributions not tax deductible
- Contributions are limited
- No employer matching plan
Traditional IRAs VS Roth IRAs
A traditional IRA allows you to make contributions either before or after taxes and the earnings you accrue are tax-deferred until withdrawals are made after the age of 59½. Roth IRA contributions are made post-tax, so your withdrawals during retirement age are then tax-free. In short, a traditional IRA will lower your tax burden during the year you make your contribution while a Roth IRA lowers your tax burden when you make your withdrawals.
|Traditional IRA Accounts||Roth IRA Accounts|
|Definition||Money contributed is done with pre-tax funds||Money contributed is funded with post-tax funds|
|Pros||Immediate tax break FDIC insured||Never required to withdraw money Can pass the account down with your estate|
|Cons||Money taxed when you withdraw Must start withdrawing by age 72||No immediate tax break|
IRA Contribution Limits
You will have to pay attention to the maximum amount you are allowed to contribute to your IRA in a given year as the limits routinely change. For 2022, the limit for individuals under the age of 50 is $6,000; individuals 50 and above are allowed to contribute $7,000 a year as a way to catch up if they have fallen behind in the past.
Withdrawing Funds From Your IRA
The good news about withdrawing funds from an IRA is that the process is simple, as you just need to contact your brokerage firm and fill out the corresponding paperwork. The bad news is that, if you are withdrawing before you reach the minimum age of 59½, there are penalties in the form of additional fees. Withdrawing prior to the age of 59½ will cost you an additional 10% on the funds that you are taking out. Keep in mind that, with an IRA, you will also have to claim the withdrawal as taxable income. For traditional IRAs, you must also start taking minimum deductions once you reach 72 or 70½ if you turned 70½ before Jan. 1, 2020.
What Is A 401(k) Account?
A 401(k) account is a retirement plan that is generally set up through your employer and run through a third-party firm selected by that employer. This allows you to contribute money for retirement pre-tax and certain employers may also offer a matching program up to a certain amount.
The Advantages Of A 401(k)
- Money deducted pre-tax
- No decisions required
- Employer matching programs
- Usually easy to roll over
The Disadvantages Of A 401(k)
- Less flexibility in investments
- Penalties for early withdrawals
- Potentially high account fees
- Employer contributions may change or not exist
Traditional 401(k)s VS Roth 401(k)s
The differences between traditional and Roth 401(k)s are virtually identical to those between traditional and Roth IRAs. The primary difference is that traditional 401(k)s are made with pre-tax funds, giving you your tax break upfront, while Roth 401(k)s are done after taxes so, any withdrawals made after turning 59½ are tax-free, assuming that you have had the account for at least five years.
|Traditional 401(k)||Roth 401(k)|
|Definition||Money contributed is done with pre-tax funds||Money contributed is done post-tax|
|Pros||May receive matching funds from your employer Immediate tax break||May receive matching funds from your employer Withdrawals after age 59 1/2 are tax-free|
|Cons||Penalties for early withdrawals||Penalties for early withdrawals|
401(k) Employee Contribution Limits
Similar to IRAs, you’ll want to keep track of what the yearly maximum contribution limit is for your 401(k) as they routinely change. For 2022, the maximum contribution amount is $20,500 if you are younger than 50. If you are older than 50, that limit increases to $27,000.
401(k) Employer Matching Contributions
Many employers may have a 401(k) matching program as a benefit or incentive to workers. This generally means that employers will match an employee’s contribution up to a certain percentage, although plans can differ. Employers are also not required to match contributions and many choose not to. Some employers may also put a limit on the amount they contribute each year as opposed to matching a percentage. Either way, any contributions made by employers essentially constitute free money to workers and should be taken advantage of. The maximum contribution that employers can give in a year is currently $61,000 or 100% of compensation, whichever is smaller.
Withdrawing Funds From Your 401(k)
Similar to an IRA, there is generally a 10% penalty for withdrawing funds from your account prior to the age of 59½. There are a few exceptions for things like unreimbursed medical bills or for disability. Also, even if you have one of the few qualifications to avoid a penalty, traditional 401(k) withdrawals are considered taxable income.
What’s The Difference Between IRA VS 401(k)?
An IRA and a 401(k) are very similar except that an IRA is generally set up and operated by an individual account holder while a 401(k) is usually offered through an employer and run by a third-party firm.
A 401(k) also has a higher maximum amount that can be contributed each year and employers may also offer some form of a matching program as a benefit. Typically, 401(k)s offer less freedom for the individual investor but both accounts are easy to set up, offer traditional and Roth options, and have similar rules for when money can be withdrawn.
|IRA accounts||401(k) accounts|
|Definition||A retirement plan set up individually and run through a firm of your choosing||A retirement plan is generally set up by an employer and run through a third-party firm|
|Pros||Flexibility in investing More selection Can pass Roth IRAs down through an estate||Employer matching programs Simple to set up Higher contribution max|
|Cons||No matching programs Lower annual contribution max||Less flexibility|
Which Is Better: IRA Or 401(k)?
As is often the case, there is no single catch-all answer to the question. IRAs and 401(k)s have similar benefits and drawbacks and both can be effective tools in preparing for retirement. But there are a few instances that could make one option better than the other.
Choose A IRA Account If…
- You want flexibility in what you invest in
- You don’t want to invest more than $6,000 a year
- Your employer doesn’t offer a retirement package
- You want your earnings to be tax-deferred
Choose A 401(k) If…
- You’re OK with a third-party handling your investments
- Your employer offers a program
- Your employer has a matching program
- You want to invest more than $6,000 in a given year
Can You Use An IRA & 401(k)?
You absolutely may set up both an IRA and a 401(k) if you desire, and it is a fairly common practice. For example, you may have an IRA set up prior to joining a company that offers a 401(k). There are no real drawbacks to having both. You may find it beneficial to have your funds diversified in multiple accounts, or you may simply want to contribute more to retirement than a single account will allow. If you have multiple accounts, it’s also a quick and easy process to roll one into the other as well.
Should Businesses Offer Retirement Plans & Contribution Matching To Their Employees?
Employee retirement plans are common benefits, and in today’s competitive market where companies are looking for ways to entice workers, offering the best employee benefits options is practically essential. These benefits are simple to set up and operate and are relatively low-cost while being a useful tool to retain employees and keep morale high.
Here are a few of the best reasons to offer retirement plans and 401(k) matches.
- Increased loyalty
- Tax credits
- Increased employee productivity
- Creditor protection
- Attractive to new talent
- Increase in employee well-being
IRA VS 401(k): The Bottom Line
You probably already know that having a 401(k) or an IRA retirement plan is a good long-term investment. Knowing which one to choose might be a bit trickier, however. The good news is that you can’t really go wrong as both plans are similar and offer long-term benefits. If your employer offers a 401(k) (especially if they offer a matching program), it’s smart to take advantage of that benefit as matching contributions are basically free money and you can make significant contributions on a yearly basis.
If your employer doesn’t offer a 401(k), or if you simply want to have the freedom to make more investment choices on your own, you will want to consider an IRA. One of these accounts is simple to set up on your own and you can choose how aggressive or conservative you’d like to be. Don’t forget, there’s nothing that prevents you from having both types of accounts as well.