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IRA vs 401(k)—What is the Difference?

February 01, 2022 · 7 minute read

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IRA vs 401(k)—What is the Difference?

Retirement isn’t what it used to be. The days when you worked for a company for 40 years, then got a pension, Social Security, and a gold watch are long gone.

Today, nobody expects to work for the same firm their whole career, most companies don’t have pensions­—and who needs a watch anyway? What’s more, most of us know that Social Security alone is not going to give us the retirement income we need—if it’s even still around 40 years from now.

If you want to retire someday, it may be time to take matters into your own hands and fund a individual retirement account, such as an IRA or a 401(k).

How Are IRAs and 401(k)s Different?

key differences between 401(k)s and IRAs

The government wants you to prioritize saving for retirement. As a result, they provide tax incentives for IRAs and 401(k)s. Some IRAs and all 401(k)s offer tax-deferred growth, and other IRAs protect those who have them from having to pay taxes down the line.

The main difference between the two is that 401(k)s are qualified employer-sponsored retirement plans. You typically only have access to these plans through an employer who offers them as part of a full-time compensation package.

In addition, your employer may choose to provide matching funds as part of your compensation, which may be equal to a percentage of the amount you contribute.

Not everyone is a full-time employee. You may be self-employed or work part-time, leaving you without access to a 401(k). Fortunately, there are other options available to you.

Anyone can set up an Individual Retirement Account (IRA) as long as you’re earning income. In fact, even if you already have a 401(k), you can still open an IRA and contribute to both accounts.

The two types of accounts also differ in how much money you are allowed to contribute and the types of investments you have access to.

Here’s a deeper look at both types of accounts and the advantages each offers.

What Is a 401(k)?

Contributions to your 401(k) are made with pre-tax dollars. This makes them tax-deductible, meaning they can lower someone’s taxable income in the year they make them, possibly resulting in a smaller tax bill.

In 2022, someone earning income can contribute up to $20,500 each year to their 401(k). If they’re age 50 or older they can also make catch-up contributions of an extra $6,500.

Catch-up contributions allow people nearing retirement to supercharge their savings in case they fell behind in their younger years. In addition to the contributions made, an employer can also match their employee’s contribution, up to a combined employer and employee limit of $61,000.

An employer may offer a handful of investment options to choose from, such as mutual funds. Money invested in these options grows tax-deferred, which can help retirement investments grow faster.

When someone begins taking withdrawals from their account at age 59 1/2, those withdrawals are subject to income tax. Any withdrawals made before then may be subject to income tax and a 10% early withdrawal penalty.

What Is a Traditional IRA?

Like a 401(k), contributions to a traditional IRA are tax deductible and may help lower someone’s tax bill.

The allowable contributions made to a traditional IRA are considerably less than to a 401(k). In 2022, IRA contribution limits are $6,000, or $7,000 for those aged 50 or older.

With a traditional IRA, investments inside the account grow tax-deferred. And unlike 401(k)s where an employer might offer limited options, IRAs are much more flexible because they are classified as self-directed. It’s possible to invest in a wider range of investments, including stocks, bonds, mutual funds, exchange-traded funds, and even real estate.

When making withdrawals at age 59 1/2, the retiree pays income tax. As with 401(k)s, any withdrawals before then may be subject to both tax and the 10% early withdrawal penalty.

At age 70 1/2 you must take required minimum distributions (RMDs) from your traditional IRA.

It’s also important to note that the tax deduction for traditional IRAs begins to phase out when you earn a certain amount of income. In other words, if you make a certain amount, the portion of your contribution you can deduct decreases. Make too much and you can’t take a deduction at all.

What Are Roth Accounts?

So far, we’ve discussed traditional 401(k) and IRA accounts. But each type of retirement account also comes in a different flavor—known as a Roth.

The main difference between traditional and Roth accounts lies in when your contributions are taxed. Traditional accounts are funded with pre-tax dollars. The contributions are tax deductible and may provide an immediate tax benefit by lowering someone’s taxable income and, as a result, their income tax bill.

Money inside these accounts grows tax-deferred and they pay income tax when they make withdrawals, typically when they’ve reached age minimum age of 59 1/2.

Roth accounts, on the other hand, are funded with after-tax dollars. Someone with a Roth retirement account won’t receive an immediate tax benefit. However, investments inside Roth accounts grow tax-free, and they are not subject to income tax when withdrawals are made at or after age 59 1/2.

Roths may be beneficial to use if someone anticipates being in a higher tax bracket when they retire than they are currently. For example, if someone’s just starting their career, they may be in a lower tax bracket than they will be once they’re more established.

It’s possible to hold both traditional and Roth accounts at the same time, though combined contributions are the same as the contribution limits on traditional accounts. And those limits can’t be exceeded. Additionally, the ability to fund a Roth IRA is subject to certain income limits . There are no income limits for a Designated Roth 401(k)s.

When Should You Use a 401(k)?

If your employer offers a 401(k), it may be worth taking advantage of the opportunity to start contributing to your retirement savings. After all, 401(k)s have some of the highest contribution limits of any retirement plans, which means you might end up saving a lot. Here are some other instances when it may be a good idea:

1. If your employer matches your contributions

If your company matches any part of your contribution, you may want to consider at least contributing enough to get the maximum employer match. After all, this match is tantamount to free money.

2. You can afford to contribute more than you can to an IRA

If you are under 50, you can only put $6,000 in an IRA, but up to $20,500 in a 401(k). After you turn 50, you can add an additional $1,000 to an IRA, but $6,500 more to your 401(k).

If $6,000 (or $7,000, respectively) feels like a reach on its own, you may not want to contribute to a 401(k). But if a higher amount seems possible for you, it may be worth going for that 401(k) account.

3. When your income is too high

Above certain income levels, you can’t deduct a traditional IRA contribution or even contribute to a Roth IRA. How much income is that? That’s a complicated question that is best answered by our IRA calculator.

It can tell you what IRA plans you can use. If you can no longer fund a Roth, or you’re not getting full deductions from your traditional IRA, it might be worth throwing your full savings power behind your 401(k).

When Should You Use an IRA?

If you can swing it, it may not hurt to fund an IRA. This is especially true if you don’t have access to a 401(k). But even if you do, IRAs can be important tools. For example:

1. When you leave your company

If things come to an end, and you move on, you may not want to leave your retirement money behind in an old 401(k). It’s easy to lose track of old plans, and companies can merge or even go out of business. Then it can become a real hassle to find your money and get it out.

You can usually roll this money into your new company’s plan, or consider rolling it into an IRA, which may give you more control over your investment choices.

2. If your 401(k) investment choices stink

If you have a good mix of mutual funds in your 401(k), or even some target date funds and low-fee index funds, your plan is probably fine. But, some plans have very limited investment options, or are so confusing that people can’t make a decision and end up in the default investment—a low interest money market fund.

If this is the case, you might want to limit your contributions to the amount needed to get your full employer match and put the rest in an IRA.

3. When you are between jobs

Not every company has a 401(k), and people are not always employed. There may well be times in your life when your IRA is the only option. If you have self-employment income, you can make higher contributions to a SEP IRA or a Solo 401(k) you set up for yourself.

4. If you can “double dip.”

If you have a 401(k), are eligible for a Roth IRA, or can deduct contributions to a traditional IRA, and you can afford it—it may be worth investing in both. Often, saving now means more money—and financial security—down the line. Once again, you can check our IRA calculator to see if you can double dip. Just remember that the IRA contribution limit is for the total contributed to both a Roth and traditional IRA.

The real question is not: IRA vs 401(k), but rather—which of these is the best place to put each year’s contributions? Both are powerful tools to help you save, and many people will use different types of accounts over their working lives.

When Should You Use Both an IRA and 401(k)?

Using an IRA and a 401(k) at the same time may be a good way to save for your retirement goals.

Funding an IRA and 401(k) at once can allow you to save more than you would otherwise be able to in just one account.

Having both types of accounts can also provide you some flexibility in terms of drawing income when you retire. For example, you might find a 401(k) as a source of pre-tax retirement income. At the same time you might fund a Roth IRA to provide a source of after-tax income when you retire.

That way, depending on your financial and tax situation each year, you may be able to strategically make withdrawals from each account to help minimize your tax liability.

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