401k vs. IRA: Which is best for you?

If you’re looking to save for retirement, you may have heard of two popular types of retirement accounts: the 401(k) and the Individual Retirement Account (IRA). Both retirement plans offer tax advantages and can help you save for the future, but they have some critical differences.

Because they offer different benefits and options, understanding the difference between the two accounts is important for determining which type works best for you.

In this article, we’ll compare the 401(k) and IRA to help you determine the best fit for your retirement savings goals.

What is a 401(k)?

A traditional 401(k) is an employer-sponsored retirement savings account. You can contribute a portion of your pre-tax income to the account, and your employer may also make contributions. The money in your 401(k) is invested in a variety of assets, such as stocks, bonds, and mutual funds, and grows tax-free until you withdraw it in retirement.

One advantage of a 401(k) is that contributions are automatically deducted from your paycheck, which makes saving for retirement easy and convenient. Because contributions are pre-tax, you can deduct them, potentially lowering your tax bill for the year. Additionally, some employers offer matching contributions, which means they will match a portion of your contributions, which can help your savings grow even faster.

What is an IRA?

An IRA is an individual retirement account you can open independently. Unlike a 401(k), IRAs aren’t sponsored by employers—in order to open one, you might shop for one on your own. You can contribute up to a certain amount each year, and the money in your IRA is invested in a variety of assets, similar to a 401(k). There are two types of IRAs: traditional and Roth.

A traditional IRA allows you to make tax-deductible contributions, which means you won’t pay taxes on the money you contribute until you withdraw it in retirement. However, you will have to pay taxes on the money you withdraw from your account in retirement.

On the other hand, a Roth IRA allows you to make contributions with after-tax dollars, which means you won’t have to pay taxes on the money you withdraw in retirement. However, you won’t get a tax deduction for your contributions.

Which is better? IRA vs. 401k

The answer to this question depends on your individual circumstances and goals. Here are some factors to consider when deciding between a 401(k) and an IRA:

Employer match

If your employer offers a matching contribution for your 401(k), it can be a powerful tool to help you save for retirement. Many employers match 4% of the employee’s salary, with some contributing more. This can help your retirement savings grow more quickly. In this way, employer match programs are essentially free money.

With few exceptions, IRAs don’t generally offer employer contribution plans. A specific type of account called a SIMPLE IRA does allow employers to contribute. However, their contributions are capped at 3% of the employee’s salary—well below many employers’ 401(k) plan contributions.

Investment options

401(k) plans often have limited investment options, while IRAs allow you to invest in a wide range of assets. An IRA may be the better choice if you prefer more control over your investments.

However, 401(k) is an effective “set it and forget it” option. While it might have limited investment options, once you sign up, your money gets deducted and invested automatically—no intervention or input from you is required.

Deciding between the two is simply a question of how actively involved you’d prefer to be in your retirement investments.

Tax considerations

Depending on your current and expected retirement tax rates, one option may be more advantageous than the other.

Traditional IRAs and 401(k)s offer tax-deductible contributions, which can reduce your taxable income in the year you contribute.

Roth IRAs and Roth 401(k)s, on the other hand, don’t offer an immediate tax benefit but allow for tax-free withdrawals in retirement.

A financial advisor could help you compare current and expected future tax rates to determine which setup might result in greater personal savings.

Fees

401(k) plans may have higher management fees than IRAs, affecting investment returns. Be sure to compare the fees of each option before making a decision.

Annual contribution limits

Both types of accounts have annual contribution limits. This represents the maximum amount of money you can contribute to your account each year. 401(k) plans have significantly higher limits than IRAs. The more you contribute to your account, the more quickly you can build your savings. These limits go up regularly.

For 2023, the annual contribution limits are:

• 401(k): $22,500
• IRA: $6,500

In addition, both accounts allow “catch-up” contributions for those ages 50 and up. These are slightly higher contribution limits for those nearing retirement. This way, retirement savers can quickly build additional wealth during their final years in the workforce. These contribution limits also go up regularly.

For 2023, the annual catch-up contribution limits are:

• 401(k): $7,500 (for a total of $30,000)
• IRA: $1,000 (for a total of $7,500)

RMDs: Traditional 401k vs. traditional IRA

For either account, you can begin taking withdrawals (called “distributions”) from your plan once you turn age 59 1/2.

Traditional 401(k) and IRA plans also come with required minimum distributions (RMDs). This is an amount of money you must withdraw from your account once you meet certain requirements. These required distributions work differently between the two types of accounts.

For traditional 401(k)s, account owners must begin taking RMDs on April 1st of the year following either their retirement or their 72nd birthday (whichever comes later).

For traditional IRAs, account owners must take RMDs starting April 1st of the year following their 72nd birthday.

However, Roth IRAs are not subject to RMDs. You can keep your retirement investment in your account for continued growth, even through your retirement. Until recently, this didn’t apply to Roth 401(k)s. However, the recent SECURE Act 2.0 eliminated RMDs for these plans, as well.

Please note: while you can take distributions before you turn 59 1/2, this is considered an early distribution and is subject to hefty penalty fees. These fees are usually 10% of your withdrawal.

Which works for you?

Ultimately, whether you open an IRA or 401(k) will depend on your individual circumstances and goals. If your employer offers a matching contribution for your 401(k), it can be a powerful tool to help you save for retirement. However, an IRA may be the better choice if you want more control over your investment choices. Be sure to consider your tax situation and the fees associated with each option before deciding.