IRA vs. 401(k)
Individual Retirement Accounts (IRAs) and 401(k) plans help people save for retirement. In each of them, you can distribute your savings for a variety of investments to help your money grow faster. Our comprehensive guide outlines the features, advantages and differences between the two.
- Written by Terry Turner
Senior Financial Writer and Financial Wellness Facilitator
Terry Turner has more than 35 years of journalism experience, including covering benefits, spending and congressional action on federal programs such as Social Security and Medicare. He is a Certified Financial Wellness Facilitator through the National Wellness Institute and the Foundation for Financial Wellness and a member of the Association for Financial Counseling & Planning Education (AFCPE®).Read More
- Edited ByMichael Santiago
Senior Financial Editor
Michael Santiago, a senior financial editor, joined RetireGuide in 2023. With over 10 years of professional writing and editing experience, he brings a wealth of expertise in creating content for diverse industries, including travel and healthcare. Having traveled to more than 40 countries across five continents and lived in Europe and Asia for several years, Michael's global perspective enriches his work. He combines his strong writing skills, editorial judgment and passion for crafting accurate and engrossing content to enhance the user experience on RetireGuide.Read More
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Barbara O’Neill, Ph.D., CFP®, AFC®, CRPC®
Certified Financial Planner™ professional, Accredited Financial Counselor™ and owner and CEO of Money Talk
Barbara O’Neill is a personal finance expert with 41 years of experience working at Rutgers University. She is a Certified Financial Planner™ professional and an Accredited Financial Counselor™. Currently, she is the owner and CEO of Money Talk, where she writes, speaks and reviews content related to personal finance. In 2020, she authored Flipping a Switch, published in 2020.Read More
- Published: August 21, 2023
- Updated: August 30, 2023
- 7 min read time
- This page features 7 Cited Research Articles
- Edited By
- Individual Retirement Accounts (IRAs) are special tax-advantaged bank accounts used to save for retirement.
- 401(k), 403(b), 457 and TSP plans are a type of retirement savings plan offered by employers. Many employers consistently contribute money to your account.
- Contributions to traditional IRAs and 401(k) plans are tax-deferred.
- For 2023, you can contribute as much as $22,500 to your 401(k) and $6,500 to your IRA if you are under 50 years of age and $30,000 and $7,500, respectively, if you are age 50 and over.
What Is an Individual Retirement Account (IRA)?
The money in an IRA is usually invested in stocks, bonds and other assets (e.g., mutual funds and CDs). Ideally, the money grows as stock market indexes increase over time and as dividends and interest payments add up. There are two types of IRAs, traditional and Roth, both of which have tax advantages.
You are eligible to contribute up to $6,500 to a traditional IRA in 2023 ($7,500 if you are age 50 and older). If you’re self-employed, you are eligible to open a Simplified Employee Pension (SEP) IRA and contribute up to 25% of your income with a limit of $66,000 Both a traditional IRA and a SEP are pre-tax accounts, which means that they are funded with money that has not yet been taxed. Taxes on contributions and earnings are deferred until you make withdrawals.
A Roth IRA is financed with after-tax dollars (i.e., money that has already been taxed). Consequently, investors are only liable for taxes on interest, dividends, and capital gains accrued within the account. However, you can only contribute to a Roth IRA if your modified gross income in 2023 is less than $153,000 (when filing single) or $228,000 (when filing jointly).
Avoid withdrawing money from your IRA before age 59 1/2. You’ll incur a 10% early withdrawal tax penalty in most circumstances on those funds. Talk to a financial advisor or tax professional when making withdrawals to ensure you pay as little tax as possible.
For increased financial security in later life, weigh the pros and cons of 401(k)s and IRAs, and consider investing in one of them or both.
Benefits and Drawbacks of IRAs
There are both pros and cons to using an IRA as a retirement strategy. Weigh the following points when deciding whether to use one.
- Highly flexible
- Allows you to defer taxes to later years
- Offer tax-free growth on contributions
- Low contribution ceiling vs. employer savings plans
What Is a 401(k) Plan?
The 401(k) plan, another retirement savings option, is solely provided by employers that offer a plan (not all do). You can contribute to a 401(k) plan by transferring money to your plan or by making contributions directly from your paycheck.
Some employers also match some or all of workers’ 401(k) contributions as an incentive to save for retirement. While you still get to make investment decisions about your money, 401(k) investments are usually limited to funds selected by your employer.
If your employer has a 401(k) plan, ask the human resources department to enroll you. You can then choose how much of your salary you’d like to contribute and which investments you’d like to buy with those funds. For the 2023 tax year, you can contribute a maximum of $22,500 to your 401(k) or $30,000 if age 50+.
You can deduct your 401(k) contributions from your federal income taxes, but you’ll pay ordinary income tax on your withdrawals later. State tax rules with respect to 401(k) contributions vary. If you contribute to a Roth 401(k), you will pay taxes on the funds you contribute, but you will not be taxed on money you withdraw during retirement.
You’ll usually face tax penalties for withdrawing money from your 401(k) before age 59 1/2. However, every plan has different rules and features depending on the company sponsoring it. Check the rules of your employer’s 401(k) plan and speak to your financial advisor to find out if there are restrictions you should be aware of.
Benefits and Drawbacks of a 401(k) Plan
Like IRAs, 401(k) plans also have benefits and drawbacks.
- Higher contribution ceiling than IRAs
- Contributions may be matched by employer
- Allows you to defer taxes to later years
- Can be rolled over in some instances to an IRA or a 401(k) at another employer.
- Less freedom to choose investments than IRAs
- May come with hefty administrative fees
- Generally tied to your employer
Comparing IRAs and 401(k) Plans
IRAs and 401(k)s have many similarities and differences. Your financial advisor can help you compare the two and decide which one makes the most sense for your needs, but here are some specifics about each retirement strategy.
|Ownership & Sponsorship||Owned and financed by you||Employer-sponsored but owned by employees|
|Contribution Limits||$6,500 in 2023 ($66,000 for a SEP IRA); $7,500 if age 50+||$22,500 in 2023: $30,000 if age 50+|
|Employer Matching Contributions||No||Sometimes – check your plan for details|
|Investment Options||Can be invested in any assets you choose||Can only be invested in assets available from employer plan|
|Withdrawal Rules||Tax penalty of 10% on early withdrawals with some exceptions||Tax penalty of 10% on early withdrawals with few exceptions|
|Portability & Flexibility||Follows you from job to job (no employer connection)||Tied to your employer|
Is an IRA or 401(k) Right for You?
When you do retirement planning, you have investment decisions to make. 401(k) plans are only available through an employer. If your employer offers one and matches contributions, you can take advantage of this to build a much larger nest egg than you could save on your own. However, you’ll be limited to the investment options your employer provides. You might also run into trouble if you change jobs often or if your employer isn’t financially stable.
In those situations, an IRA may be a better fit for your needs. While you’ll miss the benefit of employer matching and have a lower contribution ceiling, you’ll be able to choose your own investments. You’ll also have more ways to avoid paying the 10% early withdrawal tax if you need to withdraw some money before age 59 1/2.
Talk to your financial advisor about which of these two savings vehicles they recommend for your needs. They’ll advise you based on your financial profile.
Is a Roth IRA or a 401(k) the Preferable Option?
With retirement savings options, there’s no one-size-fits-all solution. Roth IRAs and 401(k)s have advantages and disadvantages that make each the better choice in certain situations.
Which is right for you?
Consider the following:
- Does your employer offer a 401(k) plan? If so, does it match contributions?
- Are you satisfied with the investment options available to you in your employer’s 401(k) plan?
- Can you afford to contribute more than $6,500 a year to a 401(k) and take advantage of the higher investment cap?
- Does it make more sense to pay taxes on your savings now or later?
Remember: It’s not always a choice between an IRA and a 401(k). Many people set up both accounts and reap the benefits of each.
FAQs About IRAs and 401(k) Plans
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7 Cited Research Articles
- Maddox, C. et al. (2023, April 19). Understanding the key differences between an IRA and a 401(k). Retrieved from https://www.businessinsider.com/personal-finance/ira-vs-401k
- Iacurci, G. (2023, February 9). Rollovers from a 401(k) plan to an IRA: Weigh these 7 factors first. Retrieved fromhttps://www.cnbc.com/2023/02/09/401k-plan-ira-rollovers-factors-to-consider.html
- Rose, J. (2023, January 17). Can You Lose Money in a Roth IRA? Good Financial Cents. Retrieved from https://www.goodfinancialcents.com/can-you-lose-money-in-a-roth-ira/
- Internal Revenue Service. (2022, November 21). Taxpayers should review the 401(k) and IRA limit increases for 2023. Retrieved from https://www.irs.gov/newsroom/taxpayers-should-review-the-401k-and-ira-limit-increases-for-2023
- Hartman, R. (2021, March 31). IRA Versus 401(k): Which Is Better? Retrieved from https://money.usnews.com/money/retirement/401ks/articles/ira-versus-401-k-which-is-better
- Michigan Department of Insurance and Financial Services. (n.d.). IRA and 401(k) Overview. Reinventing Mi Retirement. Retrieved from https://www.michigan.gov/reinventretirement/education/investment/ira-and-401k-overview
- U.S. Securities and Exchange Commission. (n.d.). Traditional and Roth 401(k) Plans. Retrieved from https://www.investor.gov/additional-resources/retirement-toolkit/employer-sponsored-plans/traditional-and-roth-401k-plans