The IRA and 401(k) are the two most common tax-advantaged retirement accounts that people use. Depending on your eligibility, savings goals, and other factors, you may use either or both for your retirement savings.
Every financial situation is different, and you ultimately should consult with a knowledgeable financial advisor before setting up either. Here’s a general breakdown of the differences between an IRA vs 401(k), though.
Understanding IRA and 401(k)s
Both IRAs and 401(k)s are tax-advantaged retirement savings accounts. They each offer tax benefits, investment opportunities, and retirement-age withdrawals. They also can differ in exactly what these features mean.
Individual Retirement Accounts (IRAs)
An individual retirement account (IRA) can be opened irrespective of employment. Anyone who has earned income can open an IRA and make contributions.
As a retirement account, funds hopefully grow in an IRA over a period of years or decades. Withdrawals can generally be made at age 59½ without penalty. Withdrawals made prior to that age are often subject to a 10% penalty unless they’re for another permitted purpose.
Types of IRAs: Traditional IRA vs. Roth IRA
IRAs come with comparatively low contribution limits, but they’re widely available to most people saving for retirement.
There are two main types of IRAs: Traditional and Roth. These primarily differ in how they’re taxed:
- Traditional IRA: Contributions may be tax-deductible in the year they are made, lowering your taxable income. Withdrawals in retirement are taxed as ordinary income. The tax-deferred benefit may allow you to see greater growth thanks to a larger initial investment.
- Roth IRA: Contributions are not tax deductible, meaning you pay taxes on contributions in the year that they’re made. Withdrawals in retirement are not taxed, however, so any growth is usually tax-free. This may result in a lot of growth that you don’t have to pay taxes on.
There’s also a minor difference in withdrawal requirements. Both IRAs generally allow you to begin withdrawing at age 59½, but whether you must make withdrawals varies:
- Traditional IRAs have required minimum distributions (RMD) beginning at age 72 or 73 (depending on birth year). If you haven’t yet begun taking distributions by then, you’ll need to with a Traditional IRA.
- Roth IRAs normally don’t have RMD requirements if you’re the person who funded the account. There may be required RMDs for inherited Roth IRAs and in certain other situations.
If you have other funds that can be used during retirement, continuing to let a Roth IRA grow tax-free could result in a large sum for your final years or heirs. (Investing comes with inherent risks, and growth isn’t guaranteed in any year.)
(There are other types of IRAs for small business owners and the self-employed. An investment advisor can review the SEP and SIMPLE IRA if either might be appropriate.)
401(k)
A 401(k) is an employer-sponsored retirement plan that allows employees to save and invest a portion of their paycheck. You’re only able to open a 401(k) if you’re employer offers the plan as an employee benefit.
Many 401(k)s include an employer match, although this is voluntary on the employer’s part. Any employer match is colloquially referred to as “free money,” because it’s awarded simply by saving for retirement.
As with IRAs, retirement withdrawals are permitted at age 59½. Early withdrawals are a little more flexible, as many employer 401(k) plans allow individuals to take out loans against their account. Loans must be repaid with interest, but it’s essentially repaying yourself. Loans are plan-dependent.
Key Differences Between IRA and 401(k)
The specific differences between IRAs and 401(k)s are explicitly laid out by federal laws and IRS rules. The most important differences are as follows. (SEP and SIMPLE IRAs have different rules not detailed here.)
1. Contribution Limits
401(k) plans usually have much higher contribution limits than either type of IRA. 2024 contribution limits are:
- IRA: 2024 contribution limit is $7,000. A catch-up allowance of $1,000 raises the limit to $8,000 for those 50 and older.
- 401(k): 2024 employee contribution limit is $23,000. A catch-up allowance of $7,500 raises the limit to $30,500 for those 50 and older. Employee and employer contributions can’t exceed $69,000 or the employee’s annual salary (not including any catch-up).
There isn’t a combined maximum contribution limit for IRAs, since only individuals are making contributions.
2. Tax Advantages
Both account types can now come with either Traditional or Roth tax advantages. The option for a Roth 401(k) was new starting 2023, and may not be widely available from employers yet.
Traditional accounts use pre-tax income for contributions, meaning that income isn’t taxed when it’s put into the account. Withdrawals are taxed when they’re pulled out. Income taxes are thus deferred. Deferring can offer more potential growth since there’s a higher starting balance, and many people have a lower income tax rate once retired than they do when working.
Roth accounts use post-tax income for contributions, meaning that income tax is assessed when contributions are made. Withdrawals aren’t taxed, however, which allows funds to potentially grow tax-free.
3. Matched Contributions
IRA plans have no contribution match. The individual account holder is the only party that makes contributions to their account.
Many 401(k) plans have an employer match on contributions that the employee makes. Matches are often limited to a certain percentage of pay (e.g. 2-5%). The amount matched is usually a percentage of the employee’s contribution (e.g. 50-200%).
As an example, assume an employer matches up to 4% of an employee’s income at 150%. If an employee earned $100,000 and contributed $4,000 (4%), the employer’s matching contribution would be $6,000.
4. Investment Options
401(k) plans typically limit investment options to a selection chosen by the employer. Most employers choose a mixture of different funds available, which might include mutual funds, targeted-age funds, large-cap and small-cap funds, real estate funds, and bond funds. Individual stock purchases normally aren’t available.
IRA plans have no such restriction, instead allowing a wide range of investments. All of the aforementioned funds are generally available through IRAs, as are individual bonds, individual stocks, and even precious metals. Some IRAs even allow for options trading, but this usually isn’t advisable for most individuals. An investment advisor can go over the increased risks that options and other derivatives present.
5. Eligibility Requirements
IRAs are available to almost anyone who has earned income, and contributions generally can be made in any year during which you have income.
401(k)s are only available to workers whose employers offer a 401(k), and contributions can only be made while working for the employer.
6. Early Withdrawal Penalties
Both IRAs and 401(k)s impose a 10% penalty for withdrawals made before age 59½, unless the withdrawal is for a permitted exception. Exceptions differ between the two account types, but they broadly entail certain medical, tuition, housing, and other necessary expenses.
The Roth IRA and 401(k) each allow for certain withdrawals to be made without penalty, even if they aren’t for a permitted exception:
- Roth IRA contributions can be withdrawn without penalty after remaining in the account for 5 years. This doesn’t apply to any gains earned within the account.
- 401(k) plans may have a loan option. The option allows borrowing against the account, and then the loan amount is repaid with interest. While interest is technically paid, the interest goes into the 401(k) account. There may be some administrative fees involved, and whether there’s a loan option is the employer’s decision. This is generally true for both Traditional and Roth 401(k)s.
Before taking an early withdrawal from either account type, consult with a financial advisor. They can review the ramifications for you, and explore whether there are any other ways to access the funds you need.
IRA vs 401(k): Choosing the Right Account for You
Choosing between an IRA and a 401(k) often depends on your specific financial situation and retirement goals. The following are only some broad common guidelines. Before making a decision, talk with a financial advisor who can provide specific guidance on your situation.
- Employer Match: If your employer offers a match on 401(k) contributions, you may want to make enough contributions that you maximize the match.
- Investment Options: Having more investment options may make an IRA slightly more attractive, but this usually isn’t enough to outweigh a 401(k)’s employer match.
- Contribution Limits: If you’re able to make large contributions toward your retirement savings, the limits of an IRA might be too low. You may make the maximum allowed contribution to an IRA, and then contribute to a 401(k).
- Tax Bracket: Consider whether you expect your tax rate to be higher now or in retirement. This decision can guide whether a Traditional or Roth account is more appropriate, regardless of whether it’s an IRA or 401(k).
- Time Frame: Your investment time frame can also affect whether a Traditional or Roth account is preferable. A Traditional account may be better if you have just a few years, but a Roth will probably be better if you have longer before retirement.
Of course, eligibility is the first consideration. As you change employment, you might use either or both of these accounts in different years.
Make the Right Choice with a Financial Advisor
There are many factors to consider when deciding whether to use an IRA, 401(k), or both. Your decision will have a large impact on your retirement savings, so it’s important to choose the option that’s best for you.
For help making this crucial choice, consider connecting with a financial advisor who specializes in retirement planning. A knowledgeable advisor can:
- Review your specific financial situation and goals
- Explain how different account types might benefit you
- Help you maximize tax advantages and growth potential
- Create a personalized retirement savings strategy
Don’t navigate this complex decision alone. Invested Better can match you with an experienced advisor who understands the nuances of retirement planning.
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