Understanding the key differences between an IRA and a 401(k)

Ira vs 401k, divided by an upwards trending arrow on investing themed background
You can save for retirement automatically, whether you use a 401(k) or an IRA . Alyssa Powell/Insider
  • A 401(k) is a retirement account funded with pre-tax dollars and has higher contribution limits but fewer investment options.
  • With an IRA, contribution limits are lower, but you have more options for your investments as well as when you’ll be taxed.
  • A 401(k) and IRA can both be used to invest in stocks, bonds, and securities for retirement.
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When you think about saving for retirement, the two most common accounts that may come up are often a 401(k) or IRA. Depending on your investment strategy, you may want to use one over the other – or a combination of both.

When evaluating a retirement plan option, you’ll want to consider factors like how much you can contribute annually, how your contributions are taxed, and when you can withdraw your money penalty-free.

Let’s examine the similarities, differences, and overall structure of IRAs and 401(k)s below.

IRA vs. 401(k): At a glance

While both are excellent retirement account options, the biggest difference between a 401(k) and IRA is that you only contribute to a 401(k) through your employer.

  • A 401(k) is an employer-sponsored plan where you contribute pre-tax dollars from your paycheck directly to a long-term investment account.
  • An IRA stands for Individual Retirement Account, which you can open without employer involvement and contribute either pre-tax or post-tax dollars to an investment account for long-term growth.

What is an IRA?

You can open an IRA with almost any brokerage or financial institution that offers retirement plans. Before you open your account however, you’ll need to decide which type of IRA you want. The three main types of accounts are Traditional IRAs, Roth IRAs, and SEP IRAs.

  • A traditional IRA is similar to a 401(k) in that you can fund your account with pre-tax income. As a result, you can deduct your traditional IRA contributions on your taxes each year.
  • With a Roth IRA, you contribute taxed dollars so you can’t deduct any contributions. When it’s time to withdraw the money from your Roth IRA account, you won’t pay taxes on it since you already paid the taxes upfront.
  • SEP IRAs, or Simplified Employee Pensions, are a flexible retirement account option for people who are self-employed.

Contribution and income limits

With both Roth and Traditional IRAs, you can contribute up to $US6,000 ($AU8,229) annually for 2021. If you’re over the age of 50, you qualify to make extra or catch-up contributions up to $US1,000 ($AU1,371) each year. Anyone can open a traditional IRA and contribute funds.

In order to contribute to a Roth IRA, your modified gross income must be less than $US125,000 ($AU171,429) if you’re single and $US198,000 ($AU271,544) if you’re married and file taxes jointly. These income limits are subject to change each year.

With a SEP IRA, you can contribute up to $US58,000 ($AU79,543) or 25% of your income (whichever is less) each year.

Withdrawal guidelines

Once you reach the age of 59.5, you can start withdrawing money from your IRA without penalties. By the age of 70.5, it’s required to withdraw from your account(s).

Generally, you can withdraw your contributions at any time. But to withdraw funds from an IRA, there’s a 10% penalty. The only exceptions to this rule include:

  • First-time home-buyers can withdraw up to $US10,000 ($AU13,714) to help with the purchase of their home (must be used with 120 days of the withdrawal)
  • Some educational expenses for yourself or your family
  • Disabled account holders can withdraw IRA funds without penalty
  • Medical expenses that are more than 7.5% of your adjusted gross income
  • Birth or adoption expenses up to $US5,000 ($AU6,857)
  • Health insurance premiums if you’ve been unemployed for at least 12 weeks

Of course, you’ll need to check with the bank, brokerage, or financial institution where you keep your IRA to confirm whether your expense qualifies to waive the 10% early withdrawal penalty. Also, try to make sure you have the proper documentation to verify that the money will go directly toward a qualified exception so you don’t face a potential fee later on.

When an IRA is better

An IRA could be better than a 401(k) if you’re looking for more flexibility in your retirement planning.

“Unlike a 401(k), with an IRA the investment world is at your fingertips,” says Taylor J Kovar, Certified Financial Planner and CEO of Kovar Wealth Management. “Stocks, bonds, mutual funds, and real estate are all available while with a 401(k), you are limited to just the funds the plan allows you to invest in.”

Another reason why an IRA could be a better option is if you currently have low tax rates but anticipate higher tax rates during retirement. By contributing to a Roth IRA, you’ll pay your taxes upfront so your growth and withdrawals during retirement are tax-free.

Not all employers offer a 401(k) plan, so an IRA is one of the best alternatives to help you save for retirement on your own.

Pros Cons
  • Open an account without your employer
  • Tax-free growth
  • Tax deductions for a traditional IRA
  • Larger investment selection
  • Range of penalty-free early withdrawal exceptions
  • Lower contribution limits than a 401(k)
  • Income limitations for Roth IRA contributions
  • 10% penalty for early withdrawals
  • Traditional IRA distributions for retirement are taxed as ordinary income

What is a 401(k)?

When a company hires you to work, they may offer you a retirement savings option in the form of a 401(k) account. These plans have been widely offered since the early 1980s after Congress established the Revenue Act which made it easier for employers to offer tax-advantaged savings accounts for employees.

With a 401(k), your employer will automatically deduct a percentage of your income from that pay period (before taxes) and contribute it to an investment account. Some employers will even offer to match your contributions if you contribute a specific amount, like 3% of your income, for example.

Contribution limits

Currently, you can contribute up to $US19,500 ($AU26,743) annually to your 401(k). If you’re 50 or older, you can make additional catch-up contributions up to $US6,500 ($AU8,914).

Withdrawal guidelines

Just like with an IRA, you will pay a 10% penalty for taking money out of your 401(k) before you turn 59.5. In addition, the money you withdraw early gets taxed as income. There are very few ways to get around this 10% penalty.

However, if you need to take money out of your retirement account, you can try a 401(k) loan. The IRS limits these loans to $US50,000 ($AU68,572) or 50% of your 401(k)’s vested account balance. The interest rates for 401(k) loans are usually lower and you don’t have to submit to a credit check.

You just need to make sure you pay the money back on-time to restore your 401(k) balance. One major downside of borrowing against your retirement account this way is if you lose your job, the entire loan balance is usually due right away.

When a 401(k) is better

A 401(k) is a better option than an IRA if you are looking to invest more for retirement and you’re not too picky about the investment options. Most plans are limited to which securities (like stocks and bonds) the employer chooses.

A 401(k) could also be better if your employer is offering to match your contributions and you plan to stay at the job for a while. If you’re contributing 3% of your income, an employer match would double that to 6%, so you’d basically be adding free money to your retirement account.

If you struggle with intentionally setting aside money to save, you’ll like the consistent pre-tax contributions before you even see your paycheck.

“Most people utilize a 401(k) through their employer and while I don’t have a problem with this, I typically recommend that people only participate in the plan up to the amount that the employer matches, typically 3%,” says Kovar. “If you are able to save more than what the employer matches, put that extra money into an IRA.”

Pros Cons
  • High annual contribution limit
  • Employer match if offered
  • Contributions are tax-deductible
  • Income does not determine your eligibility
  • No control over investment options
  • No control over management fees
  • Very few options to avoid the 10% penalty for an early withdrawal
  • Distributions are counted as taxable income

The financial takeaway

A 401(k) and IRA are both great tax-advantaged retirement savings options and many people use both. If your employer offers 401(k) with a contribution match, you should definitely consider utilizing it. Keep in mind that in order to take full advantage of the matched contributions – also referred to as being “fully vested” – you may need to stay at your job for a few years.

Not everyone has the option to save for retirement through an employer and that’s where an IRA can come in handy. While the contribution limits are lower, you can still open an IRA to manage retirement savings regardless of where you work.

Another option is to use an IRA to diversify your retirement savings accounts. Consider talking to a financial advisor about your options and weigh the tax advantages, benefits, and drawbacks to make the wisest choice for your situation.

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