401(k) vs. IRAs: What’s the difference and which is better for saving for retirement?

💡 Key takeaways:

• 401(k) plans and IRAs are both important tools you can use to save for retirement.
• You get a 401(k) plan from your employer, if they offer it.
• You can open an IRA on your own, usually from a bank or broker.
• You can contribute to a 401(k) and an IRA in the same year if you’re eligible for both.

If you're new to saving for retirement and trying to learn the basics, you may encounter the word "should" often. There's no shortage of advice pointing you in different directions — "you should contribute to your 401(k)" or "you should open an IRA."

We'll be upfront. There's no way we can know how you "should" save for retirement. Saving for retirement is personal — it's all about what best supports you and your individual situation. So in this post, we're going to break down the differences between saving with a 401(k) and an IRA, but as always, consult a tax professional about what makes the most sense for you.

At a high level, there are two key differences between 401(k)s and IRAs:

• A 401(k) is an employer-sponsored retirement savings plan. An IRA is an Individual Retirement Account set up by you without involving your employer.
• 401(k)s have higher annual contribution limits than IRAs.

Now let’s dive into some key definitions and important differences between 401(k)s and IRAs.

Understanding 401(k) plans

A 401(k) is an employer-sponsored retirement savings plan. It's also a "defined-contribution plan," which means you know exactly how much money is going in the plan that is solely for your benefit. 401(k) plans also allow you to defer part of your paycheck to contribute to it, typically before taxes are taken out. This lowers your taxable income, which can reduce the amount of tax you owe.

Later, often in retirement, you will pay taxes on the amount you take out. If you do not also meet the requirements to have a "qualified distribution" you will also pay an additional 10% penalty excise tax. There are many specific rules for qualified distributions, but the main thing to remember now is that if you are age 59 ½ or older you are exempt from the penalty tax. and you generally have to take some required minimum distribution in your early 70s. There are other circumstances that could be considered a qualified distribution, so it pays to dig into those specific rules if they're relevant to you.

There are also Roth 401(k) plans. These are similar to traditional 401(k) plans, except for the tax treatment. With a Roth 401(k), you will pay regular income tax on your earnings and then contribute them to your plan. But down the road, when you take qualified distributions, those will be tax-free.

Your employer can contribute to both 401(k) types. This is typically called "matching," as many employers match the amount you put in up to a certain percentage.

Benefits of saving with a 401(k) plan

There are many benefits to saving for retirement with a 401(k) plan. These include:

• Employer matching: Just what it sounds like, your employer can choose to match a certain amount of your contributions. This can really help your retirement savings add up. There are annual limits for total 401(k) contributions, including employer matching.
• Tax benefits: 401(k) plans allow you to reduce your taxable income with your pre-tax contributions. Later, you will pay taxes when you take qualified distributions. Some people prefer this, as they plan to be in a lower tax bracket in retirement. A Roth 401(k) allows you to pay taxes now and then avoid them later when you take qualified distributions. This may be preferable for those who plan to be in a higher tax bracket in retirement.
• Loan provisions: With some 401(k) plans, you can take a short-term tax-free "loan" from your plan. In essence, this is just accessing the funds you've already saved and paying them back on a set schedule (usually in less than 5 years, unless the funds were used to buy your primary residence). Since this isn't included in all 401(k)s, it's a good idea to check with your plan sponsor to see if this is available to you.
• Higher contribution limits: 401(k) plans have higher contribution limits than IRAs, making them a good choice if you're looking to put away a lot of savings for retirement.
• No income limits: You can contribute to a 401(k) no matter how much you make.

While there are many benefits to having a 401(k), there are a few considerations to keep in mind as you plan for retirement. One is that investment choices can be more limited with a 401(k) than with an IRA, which means that what you can invest in is up to your plan sponsor.

Also, there are a lot of specific rules for 401(k)s, especially around withdrawals and qualified distributions. It pays to check these rules out and make sure they sound like they're a good fit with your retirement goals. Some people choose to have both a 401(k) and an IRA to get the benefits of both.

Understanding IRAs

An IRA is an Individual Retirement Account, and the name provides a big hint as to what makes these accounts different from 401(k) plans. IRAs are opened and managed by you as an individual. They are not employer-sponsored. Typically, you can open an IRA with your bank, brokerage, or other financial institution.

Because you manage your IRA as an individual, you won't be able to have pre-tax money go straight to the account from your employer, like you would with a 401(k). But you may qualify to deduct it from your taxable income. (We say you may qualify for a tax deduction because there are certain income and eligibility requirements you must meet. If this is the path you want to take, be sure to check out those requirements.)

There are also Roth IRAs. Roth IRAs are similar to Roth 401(k)s in that you will contribute after tax funds, then your qualified distributions will be tax-free.

Benefits of saving with an IRA

Just like 401(k)s, there are many benefits of saving for retirement with an IRA. These include:

• Wide range of investment options: Typically IRAs have a wider array of investment options, such as stocks, bonds, mutual funds, and ETFs. That’s because they are offered through banks and brokerages. It can be a good idea to work with an advisor to ensure you select the right investments for your personal goals.
• Tax benefits: Roth IRAs allow you to pay taxes when you contribute, so you don’t have to pay them when you withdraw funds. This can be beneficial if you plan to be in a higher tax bracket in retirement or don’t want to worry about paying taxes later on.
• Accessibility: Because you can open an IRA as an individual, you don’t need to have an employer that offers one. This makes IRAs much more accessible. This is beneficial if you are working as an independent contractor, if your employer does not offer a 401(k), or if you have a 401(k) but want an additional tool to save for retirement.

There are also some key considerations if you're thinking about getting an IRA. One consideration is lower contribution limits. IRAs have lower annual contribution limits than 401(k) plans.

Another consideration is income limits. For Roth IRAs, if you make over $146,000 in 2024, you will start to be limited in how much you can contribute. If you make from $146,000 to $161,000, you can make a partial contribution. If you make over $161,000, you can't make any contribution.

Key differences: 401(k) vs IRA

Withdrawal rules and penalties

As you're probably starting to figure out, 401(k)s and IRAs are governed by a lot of rules and regulations. The same goes for withdrawing money from a 401(k) or IRA. Here are a few things to keep in mind when planning out your withdrawals:

Age: For a 401(k) and IRA, you can take qualified distributions when you reach age 59 ½, and you must take required minimum distributions at age 72, 73, or 75. The same goes for a Roth 401(k) and Roth IRA, plus the account must be at least 5 years old. For a Roth IRA, there is an exception to the age and 5+ year old account limits. If you use the withdrawal (up to a $10,000 lifetime maximum) to pay for a first-time home purchase, that is also considered a qualified distribution.

Penalties: If you make a withdrawal that is not an appropriate qualified distribution, you could be subject to a 10% penalty. With a 401(k) and an IRA, you will also have to pay the appropriate income tax. It is also important to note that certain employer contributions to your 401(k) can be subject to a vesting schedule. This means that you may need to work a certain amount of time for the employer (no more than 6 years) or you may forfeit a certain percentage of your employer contributions.

Common deciding factors when choosing between an IRA and a 401(k)

As you probably know by now, it is possible to have both an IRA and a 401(k) if your employment situation and financial goals allow. But for some people, the stars don’t align. So, how do you choose between saving with an IRA and a 401(k)? There are a few things to consider that can help you make the call.

Employment status: This is the big one for many people. If you are employed at a company that offers a 401(k), then you can choose to enroll. If your company doesn’t offer one, you’re out of luck. Same goes for if you’re an independent contractor. In those cases, you can choose an IRA to put away some retirement savings.

Financial goals and retirement plans: Everyone has their own unique situation and goals when it comes to planning for retirement. How much money you need or choose to save will be influenced by some very personal factors, such as how much money you make, where you live, if you own a home, how many children you have, your health status, and more.

At the end of the day, it’s about whatever works best for your unique situation. That’s why it’s such a smart idea to hash out your goals and make plans with an investment or tax professional.

Saving with both a 401(k) and an IRA

Can you have both a 401(k) and an IRA? The short answer is yes. You can have both a 401(k) plan and an IRA. You can also have a 401(k) or Roth IRA, or a Roth 401(k) and an IRA, or any combination of plans you see fit.

The more plans you have, the more things have the potential to become confusing. It is essential to stay on top of all plan rules and regulations. This is especially important when it comes to contributions, because you have to stay within both plans’ contribution limits for the year. But as long as you are on top of your game, there’s no reason you can’t incorporate both a 401(k) and an IRA into your retirement planning.

Disclosures:

The information provided herein is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax, legal and/or financial advice that considers all relevant facts and circumstances. You are advised to consult a qualified financial adviser or tax professional before relying on the information provided herein.