IRA vs. 401(k): What’s the Difference?

An individual retirement account (IRA) and a 401(k) are two common types of retirement accounts that offer tax advantages when you invest. The key difference between the two is that an IRA is a type of retirement account that you open, fund, and invest on your own, while a 401(k) is a retirement account you open through your employer.

If you want to know more about the differences between an IRA and a 401(k), you’re in the right place. Learn more about how each type of retirement account works, who can contribute, and which one makes sense for you.

What’s the Difference Between an IRA and a 401(k)?

An IRA is a tax-advantaged retirement account that stands for “individual retirement arrangement,” although it’s typically referred to as an individual retirement account. Typically, an IRA is an account you open for yourself as an individual. However, a few types of IRAs, such as a simplified employee pension (SEP) or a Simplified Incentive Match for Employees (SIMPLE) IRA, allow an employer to open and fund an account on your behalf.

A 401(k) is a type of retirement savings plan employers can set up on their workers’ behalf. As with an IRA, you get tax advantages for saving in a 401(k). Some companies also contribute to employees’ accounts—called an employer match. A 401(k) operates under the rules of the Employee Retirement Income Security Act (ERISA), a federal law that sets minimum standards for private-sector workplace retirement plans.

The tax advantages you get with an IRA versus a 401(k) depend on the type of account, and the withdrawal rules vary. However, if you take money out of either account before age 59½, you could owe taxes and a 10% penalty.

Types of IRAs

The two main types of IRAs are:

Traditional IRA

A traditional IRA is an IRA that lets you make tax-deductible contributions depending on your income, tax filing status, and whether you’re covered by a workplace retirement account. Your money grows on a tax-deferred basis and is generally taxed when you withdraw it.

Roth IRA

A Roth IRA is a type of IRA you fund with post-tax dollars. Although you can’t deduct your contributions for tax purposes, your withdrawals are tax-free in retirement if you follow certain rules.

You may also be penalized for withdrawing your earnings early, although you can access your contributions whenever you want without paying taxes or penalties.

401(k) Tax Treatment

With a 401(k), you defer a portion of your salary or income into your retirement account, which is usually invested in various bond funds or mutual funds. However, the tax treatment can be different depending on the type of 401(k) plan.

Traditional 401(k)

• Pretax contributions: Your contributions are deposited pretax or before income taxes are taken out of your paycheck, which can lower your taxable income in the year of the contribution.
• Tax-deferred earnings growth: As your balance is invested over the years, it grows on tax-deferred, meaning you pay no capital gains taxes on investment income.
• Distributions are taxed: Any withdrawals or distributions in retirement are taxed at your income tax rate at that time.

Roth 401(k)

• After-tax contributions: A Roth 401(k) is similar to a regular 401(k) but with different tax treatments. Contributions are made after tax or after income taxes have been deducted from your paycheck. In other words, you don't get an upfront reduction in your taxable income when you make contributions.
• Tax-free earnings growth: As your balance is invested over the years, you don't pay any taxes on the earnings in retirement.
• Tax-free distributions: With a Roth 401(k), you don't pay any income taxes on withdrawals in retirement as long as you are 59½ and have held the account for at least five years. However, if you had received employer contributions through a matching program, they must be held in a separate account and are taxed upon distribution.
  

As of 2020, nearly 90% of 401(k)s also offer a Roth option for employee contributions, according to the Plan Sponsor Council of America’s 64th Annual Survey of 401(k) and Profit Sharing Plans.

Eligibility

To contribute to an IRA, you need to have earned income for the tax year. Earned income essentially is money you earn from working, such as wages, salary, bonuses, tips, and self-employment income. Investment income, Social Security benefits, unemployment benefits, annuities, and pensions don’t count. A Roth IRA also has income limits.

If you’re married and file a joint tax return, you’re also allowed to fund an IRA for your spouse, even if they have little or no earned income. You can contribute the lesser of the contribution limit times two or your combined income for the tax year through what’s often referred to as a “spousal IRA.”

You can only contribute to a 401(k) if your employer offers one. Generally, employers must allow employees to participate in the plan if the employees are at least age 21 with at least one year of service. Employers can set their own rules in their plan document, but the rules can’t be more restrictive.

For example, a company could allow workers who are 18 years old or have only been at their job for six months to participate. But they couldn’t limit participation to employees over 25 or require two years of service.

Contribution Limits

IRAs and 401(k)s have different annual contribution limits, which are established by the IRS, effectively capping the amount you can contribute each year.

IRA Contribution Limits

The IRA contribution limit for 2022 is $6,000 ($6,500 in 2023) if you’re younger than age 50. If you’re age 50 or older, you’re allowed an additional $1,000 catch-up contribution for both 2022 and 2023. The limits apply to both traditional and Roth IRAs.

You can only contribute the amount of earned income you have for the year. If you only make $4,000 in 2022, your maximum contribution for the year will be $4,000.

401(k) Contribution Limits

The annual contribution limit for 401(k)s is $20,500 in 2022 ($22,500 in 2023). You can make an extra $6,500 in catch-up contributions in 2022 ($7,500 in 2023) if you're age 50 or older.

Employee and employer contributions can’t exceed $61,000 in 2022 ($66,000 in 2023) or 100% of the employee’s total pay. However, the catch-up contribution doesn’t count toward the limit.

Other Considerations

An IRA offers a lot more flexibility compared to a 401(k). You can open an IRA at the brokerage of your choosing. You can invest in whatever individual stocks, bonds, mutual funds, and exchange-traded funds (ETFs) your brokerage company offers.

You can only invest in a 401(k) through your employer. Your account is managed by the third-party administrator your company chooses. Your investment options are a lot more limited, although most plans offer at least three investment options, with mutual funds being the most common. However, the average plan offers eight to twelve investment options.

Which Is Right for You?

The good news is if you’re trying to choose between an IRA and a 401(k), you don’t have to choose one or the other. You’re allowed to invest in both types of retirement accounts, provided you meet eligibility rules. However, a lot of people don’t have room in their budgets to max out both an IRA and a 401(k).

A good rule of thumb is to prioritize your employer’s match. Suppose your company matches 50% of your contributions, up to 5% of your salary. That’s an automatic 50% return on your investment, so you’d want to take advantage. If you’re earning a $50,000 salary, aim to save at least $5,000, or 10% of your salary, so you can get your full match.

From there, you may want to fund an IRA if you have more money to invest. Once you’ve reached the contribution limit, you can allocate any leftover money you have to invest into your 401(k).

Frequently Asked Questions (FAQs)