IRA vs. 401(k): What’s the Difference?
The key differences between a 401(k) and an IRA retirement savings plan are that a 401(k) plan is employer-sponsored and has an annual contribution limit of $22,500 or $30,000 for those age 50 and older. An IRA retirement plan is available to anyone regardless of employment status. However, the annual contribution limit is $6,500 or $7,500 for those 50 and older. Both plans have options for either tax-deferred or tax-free growth.
What Is an IRA?
An IRA, or Individual Retirement Account, is a retirement savings account that provides either tax-deferred savings or tax-free growth, depending on whether you choose a traditional or Roth IRA. Opening an IRA to save for retirement is an option for anyone, unlike opening a 401(k), which is only available to employed individuals.
It’s possible to hold nearly any type of asset inside an IRA. Stocks, bonds, and mutual funds are common IRA investments. But you can also buy and sell options or hold real estate inside this retirement fund. While IRAs offer flexibility in terms of which types of assets you can hold, the amount you can invest each year is limited.
As of 2023, you can contribute a maximum of $6,500 per year to an IRA, although individuals over the age of 50 may contribute an extra $1,000.
- Tax-free or tax-deferred growth
- Available regardless of employment status
- Flexibility of assets
- $6,500 limit (or $7,500 if you’re over age 50)
- Early withdrawal tax
Different Types of IRAs: Traditional vs. Roth IRA
The two most common types of IRA accounts are the traditional and the Roth IRA. The main differences between these two types of accounts are:
- Tax benefits
- Required minimum distributions
- Income limits
Here’s what you need to know about each type:
A traditional IRA is a tax-deferred savings account. All contributions to this account are pre-tax dollars, meaning the money you put toward your IRA will lower your current taxable income. When you access your funds at age 59 ½ or older, your withdrawals will be taxed as regular income, but you won’t be subject to a capital gains tax.
Personal finance educator Rose Han says, “Outside a retirement account, you typically have to pay capital gains taxes when your stock investments increase in value. Given that 94% of your retirement nest egg is going to come from stock market growth, investing inside a traditional IRA is going to save you so much money in taxes.”
Traditional IRAs have a required minimum distribution, which begins at age 72. This means you cannot leave your savings in your account indefinitely.
Traditional IRA Pros:
- Contributions lower your taxable income
- No capital gains tax on profit
Traditional IRA Cons:
- Withdrawals during retirement are subject to income tax
- Required minimum distributions begin at age 72
- You cannot access contributions or profit until age 59 ½ without a penalty
Roth IRA contributions are after-tax money. This means your current bill won’t be lower when it’s time to pay taxes, but when it’s time to make withdrawals in retirement, that money will be completely tax-free. Additionally, there is no requirement to withdraw money from a Roth IRA once you hit age 72, and you can even pass your Roth IRA to your heirs after your death.
If you make between $130,000 and $144,000 in a year as a single person or between $205,000 and $214,000 as a married couple, your annual IRA contribution limit will be lower than the usual $6,500. If your annual income exceeds those numbers, you won’t be eligible to contribute to a Roth IRA at all.
Roth IRAs have greater liquidity than traditional IRAs. While there will be a 10% tax if you withdraw your Roth IRA’s profit before age 59 ½, you can withdraw your contributions at any time.
Roth IRA Pros:
- All profit is tax-free
- No required minimum distributions
- You can withdraw contributions at any time without a penalty
Roth IRA Cons:
- Does not lower your current tax bill
- High-income individuals are not eligible
How to Open an IRA
- Decide between a traditional or Roth IRA: A Roth IRA is likely the best option for individuals who are young and in a low tax bracket. However, investor Graham Stephen says, “A Roth is not a good investment if you’re making a ton of money right now in your prime earning years and you expect to make less money by the time you retire.”
- Open your account: You can open an IRA with a bank, brokerage firm, or robo-advisor. Robo-advisors typically have low fees and appeal to investors interested in hands-off retirement savings. While brokerages can have higher fees, they come with expert financial support. Whichever institution you choose, you’ll likely need to provide an ID, personal information, contribution method, and banking information.
- Fund your IRA: You can add funds through direct bank transfers, checks, electronic payments, or by rolling over money from a different retirement account.
- Start investing: With money in your account, you can begin adding assets. It’s a good idea to choose a diverse array of securities and investments to ensure you’ll see positive growth over the long term.
What Is a 401(k)?
A 401(k) is an employer-sponsored retirement savings plan. Individuals can contribute up to $22,500 to a 401(k) annually or $30,000 for those over age 50. Many companies offer a contribution match, which means your employer will contribute a certain amount based on how much you contribute.
For example, if your employer matches all contributions up to 2% of your salary, each time you put 2% of your salary into your 401(k), your employer will double that money. The Bureau of Labor Statistics reports the average employer match is 3.5%.
Rose Han says, “An employer 401(k) match is free money, so if your job offers it, you should ALWAYS max that out. Period. Never say no to free money.”
Because 401(k)s are employer-sponsored, if your employer offers this benefit, you’ll typically be guided through the process of opening your account upon joining the company. At that time, you’ll select the type of 401(k) you’d prefer, investment choices, and desired contribution amounts. If you work for a company without a 401(k) but have not set it up, ask your employer how you can do this.
- Tax-free or tax-deferred growth
- Can contribute up to $22,500 per year or $30,000 for those over 50
- No income limits
- Only available through an employer
- Limited flexibility and control of securities inside your account
- Early withdrawal penalties
- Required minimum distributions
Different Types of 401(k) Plans
Similar to IRA accounts, 401(k) savings plans commonly have a traditional or a Roth option. Unlike IRAs, both traditional and Roth 401(k) plans have required minimum distributions and early withdrawal penalties for both contributions and profits. The primary difference between these two types of 401(k) plans is how they are taxed.
- Traditional: Contributions are pre-tax, which lowers your taxable income. With annual contribution limits of $22,500, your traditional 401(k) contribution amounts can bring your tax bill down by a significant amount.
- Roth: Contributions to a Roth 401(k) are post-tax. Just like the Roth IRA, this savings plan will not lower your taxable income in the present, but withdrawals in retirement are tax-free.
Similar to IRA savings plans, the right 401(k) plan for you depends on whether you are a high-income individual or expect to surpass your current income more in retirement. Individuals who currently have a high income can benefit greatly from the reduced tax bill of the traditional 401(k). However, individuals who expect to make more money in retirement would benefit more from the tax-free growth of the Roth 401(k).
Which Is Better: 401(k) or IRA?
If you have access to a 401(k) through your employer, it’s best to take advantage of that while you can, especially if your employer matches your contributions. But to maximize your retirement savings, it’s best to open both 401(k) and IRA savings accounts.
Opening both types of retirement accounts allows you to increase your annual contribution limit to $29,000 or $37,500 for those older than 50, ensuring you have enough in retirement to live comfortably.
Other Options for Retirement Savings
Whether you choose to invest in a 401(k), IRA, or both, if you want to contribute more than roughly $28,500 per year, you’re out of luck. Similarly, if you’d like to make withdrawals before age 59 ½, you’ll need to look at other investment options. Here are some alternative ways to build wealth and savings:
- Savings Bonds: Government savings bonds, like I bonds or EE bonds, offer guaranteed returns. Current I bond rates are 6.89%, while EE bond return rates are 2.1%. Corporate bonds are also a good investment option because of the higher returns. However, there is an increased risk compared to government bonds.
- Annuities: An annuity allows individuals to pay upfront to guarantee they’ll receive a certain amount of income for a fixed period of time or until death. An annuity is a contract with an insurance company. In exchange for an upfront payment, owners of fixed annuities are guaranteed a certain amount of income for a fixed period of time or until death. Average annuity fixed rates in 2022 are between 3.6% and 5.25% ranging from 2 years to 10 years in length.
- ETFs and Mutual Funds: ETFs and mutual funds are pooled investment funds with lower risk than investing in individual stocks because these funds invest in diversified assets. Most ETFs aim to match the market’s returns, which have seen an 11.88% average annualized return since 1958. Many mutual funds aim to beat the average market returns, but there’s an increased risk to investing in mutual funds.
To learn more about wealth-building, check out the articles below:
How to Invest $100,000 for Maximum Returns and Minimum Risk