401(k) vs. IRA: What’s the difference?
November 3, 2022 7 min read
But what are 401(k)s and IRAs anyway? How exactly do they work? What are the differences? And can you have both a 401(k) and an IRA? Read on to learn the answers to these questions and more.
- 401(k)s are employer-sponsored investment accounts that help you save for retirement.
- IRAs are also investment accounts that help you save for retirement. But they aren’t employer sponsored and can be opened on your own through a financial institution.
- There are Roth versions of both 401(k)s and IRAs. Roth 401(k)s and IRAs are funded with post-tax money and investments grow tax free.
- Employers often make matching contributions to 401(k)s.
- 401(k)s have higher contribution limits than IRAs, but IRAs typically offer more flexibility when it comes to investment options.
What is a 401(k) & how does it work?
A 401(k) is an investment account offered by an employer to provide an incentive for employees to save money for retirement. The idea is that—thanks to the power of compound interest—the investments will grow over time. Then, when the employee retires, they’ll have access to the money in the account.
With a 401(k), an employee chooses a percentage or specific amount of money they would like taken out of their paycheck. The employer then automatically deducts this amount and invests the contribution in financial products—like mutual funds, stocks and bonds—that the employee has chosen.
One of the perks of 401(k)s is that many employers choose to contribute to their employees’ accounts as well. Referred to as “matching contributions” or an “employer match,” these contributions vary and employers choose how much of a match they offer. For example, a company might contribute a 50% match up to 6% of an employee’s salary.
Keep in mind that there’s typically a vesting period—often two to six years—for matching contributions. That means that the matching contributions don’t fully belong to the employee—they aren’t “fully vested”—until the end of the vesting period. And if the employee leaves the company before they’re fully vested, they may have to forfeit some of those matching contributions.
Traditional 401(k) vs. Roth 401(k)
There are different types of 401(k) plans, and the most common are a traditional 401(k) and what’s known as a Roth 401(k). The main difference between the two is when exactly they’re taxed.
Traditional 401(k) contributions are made with pretax dollars. And both the contributions and earnings grow tax deferred. Then, when the money in the account is withdrawn in retirement, it’s considered to be income by the Internal Revenue Service (IRS) and is taxed at the current rate.
On the other hand, Roth 401(k) contributions are made with after-tax dollars. And when the contributions and earnings are withdrawn in retirement, they’re generally tax free.
The tax implications of a traditional 401(k) vs. a Roth 401(k) might be better or worse for someone depending on a variety of factors—like age, current income and what someone’s income will be when they retire.
So if you’re trying to choose between a traditional 401(k) and a Roth 401(k) and aren’t sure which is the better option for you, consider meeting with a trusted financial expert for guidance.
What is an individual retirement account (IRA) & how does it work?
An IRA is similar to a 401(k)—it’s a retirement account that allows someone to invest in financial products like mutual funds, stocks and bonds. The contributions and earnings can then be withdrawn from the account in retirement.
Unlike a 401(k), however, an IRA isn’t employer sponsored. Instead, an IRA is a retirement account that someone can open on their own through a financial institution like a bank, credit union or broker.
Traditional IRA vs. Roth IRA
Like 401(k)s, there are different types of IRAs, and the most common are a traditional IRA and a Roth IRA.
With a traditional IRA, contributions are made with pretax dollars. And the contributions and earnings grow tax deferred—they aren’t taxed until they’re withdrawn in retirement.
With a Roth IRA, contributions are made with after-tax dollars. And the contributions and earnings are generally tax free when they’re withdrawn in retirement.
As with traditional and Roth 401(k)s, the tax implications of a traditional IRA vs. a Roth IRA might be better or worse for someone depending on factors like age, current income and what someone’s income will be at the time of retirement.
Meeting with a trusted financial expert can help someone choose which option might be better for them.
Differences between 401(k)s and IRAs
Aside from employer sponsorship, there are a number of differences between 401(k)s and IRAs. Here are some of the most important differences to consider:
When investing in a 401(k), an employee is limited to the options chosen by their employer—usually bond funds and stock funds, as well as balanced funds, which offer a combination of bonds and stocks.
With an IRA, on the other hand, you typically have a wider range of available options, including certificates of deposit and individual stocks and bonds.
The IRS sets contribution limits for the amount that an individual can invest in a 401(k) or IRA each year. And these annual contribution limits are often adjusted to account for factors like inflation.
For example, the 401(k) contribution limit was increased from $19,500 in 2021 to $20,500 in 2022. And that limit applies only to employees—employer contributions don’t count toward the limit.
Those aged 50 and older may be able to make an additional contribution—what’s known as a “catch-up contribution.” The current catch-up contribution limit is $6,500.
For IRAs, on the other hand, the maximum allowed contribution is $6,000 for the 2022 tax year. And those aged 50 and older may be able to make a catch-up contribution of $1,000.
For 401(k)s and traditional IRAs, you can make penalty-free withdrawals from your account at age 59½. If you withdraw funds earlier than that, you’ll typically have to pay a penalty fee of 10%. You’re also required to take distributions from 401(k)s and traditional IRAs by age 72.
Roth IRAs work a little bit differently. As long as the account has been open for five years, withdrawals can be made without taxes or penalties. And the account holder isn’t required to take distributions at a specific age.
Can I have a 401(k) and an IRA?
You can have both a 401(k) and an IRA. And because of the contribution limits associated with the accounts, having both a 401(k) and an IRA could allow you to invest more money toward retirement than if you only had one or the other.
401(k)s vs. IRAs in a nutshell
401(k)s and IRAs both allow you to invest in financial products to earn money to use in retirement. 401(k)s are employer sponsored and often come with matching contributions to help employees invest even more. IRAs, on the other hand, aren’t employer sponsored and have lower contribution limits than 401(k)s—but they also offer more flexibility and investment options.
Ultimately, a qualified financial professional can help you decide whether investing in a 401(k) or IRA—or both—is right for you.