401k vs. IRA

In this article...
  • Investing in a 401(k) or IRA builds retirement savings and offers tax benefits. There are income and contribution limits and withdrawal rules for each plan. A financial advisor can help you choose the best option for you. 

Traditional IRA vs. 401K: What to Know

Saving money for retirement is critical to ensure for a comfortable life after you’re done working. Most people can no longer count on a pension to support them and need to put their own money aside.

There are a number of ways to do that. Two of the most common vehicles are:

  • 401(k) account
  • Individual retirement account (IRA)

Which should you choose? Here’s what you need to know.

What Is a 401(K)?

A 401(k) is a type of retirement account that is available only through an employer. It is also known as a defined contribution plan.  

You typically contribute to your 401(k) through payroll deductions that are taken out of your paycheck. The Internal Revenue Service (IRS) sets limits on how much anyone can contribute to a 401(k). In 2023, those limits were:

  • Up to $22,500 if you are younger than 50
  • Up to $30,000 if you are 50 or older

The higher limits for older investors are called “catch up” contributions to help them save more as they get closer to retirement age.

401(K) Matching Contribution

Some companies offer to match a portion of your contribution, usually between 2% and 10%, often depending on how much you invest and how long you have been with the company. For example, if you contribute 6% of your yearly salary to the 401(k), then your employer will add a matching contribution of, say, 3%. If you contribute less than the full 6%, the employer may offer a lower contribution or none at all.

The IRS has limits on total contributions (including both employee and employer). In 2023, those limits were:

  • Up to $58,000 if you are younger than 50.
  • Up to $64,500 if you are 50 or older.

How to Invest in a 401(K)

How the money is invested is up to you. But most 401(k) plans have limited choices for investing. These are usually a selection of mutual funds selected by the plan sponsor. You can choose how aggressive or conservative you wish to invest by selecting the funds that match those criteria. The income earned is tax-free.

Some employers also offer the option of a Roth 401(k). In the traditional 401(k), you do not pay taxes on the amount you invest, but you do pay taxes when you withdraw money. The Roth plan is just the opposite: you contribute after-tax dollars, but generally don’t pay taxes on the withdrawals.

In most situations, you can’t withdraw money until age 59½ or you will pay penalties.

What Is an IRA?

As the name implies, an Individual Retirement Account is an account you set up yourself. There are both traditional and Roth IRAs, with the same tax implications as the 401(k).

There are also other types of IRA:

  • Simplified Employee Pension (SEP) IRA.

These options are, as the names imply, simpler to set up and administer. They are often used by smaller companies (fewer than 100 employees) and those who are self-employed. They have different contribution limits and matching contribution rules.

To open an IRA, you must be working and earning an income. If you are married and not working, you can set up a spousal IRA. However, there are income limits for both a traditional IRA and a Roth IRA. There are also penalties for withdrawal before age 59½, with a few exceptions, such as:

  • Higher education costs
  • A first home purchase (up to $10,000)
  • Health insurance if you are unemployed

The IRS limits for IRA contributions in 2023 were:

  • Up to $6,500 if you are under 50
  • Up to $7,500 if you are 50 or older

How to Invest in an IRA

Unlike in a 401(k), an IRA allows you to invest any way you like. IRAs are managed by brokerage and investment firms. They are able to offer IRA owners such investments as:

  • Stocks
  • Bonds
  • Mutual funds
  • Certificates of deposit (CD)
  • Real estate trusts

What Are the Important Differences?

The most important differences between 401(k)s and IRAs are:

  • A 401(k) is only available through an employer. Anyone with eligible earned income can open an IRA
  • A 401(k) has higher contribution limits than an IRA
  • A 401(k) may allow for an employer match. An IRA does not
  • An IRA typically has more investment choices than a 401(k)
  • An IRA allows you to avoid the 10% early withdrawal penalty for certain expenses

Is a 401(k) or an IRA Better?

The answer to that question depends on your employment situation, age and other factors. It’s best to talk to a financial advisor for guidance.

However, in general, experts suggest the following:

  • If your employer offers a 401(k) with a company match, choose this option and contribute enough money to get the full match offer. A 401(k) also allows you to invest more each year than an IRA.
  • If your employer doesn’t offer a company match, it may be better to go with an IRA. This gives you more investment options and more control over those investments.
  • And, if you have enough money, consider both. Meet your maximum allowed contribution in one, and then contribute to the other as well.
About the Author

David Levine is an award-winning writer and editor whose work has been featured in the New York Times, New York Daily News, Sports Illustrated, American Heritage, U.S. News & World Report and others.

David has covered health, health insurance and health policy topics – among many others – since 2017. He earned a Bachelor's Degree in English from the University of Rochester and currently lives in Albany, New York.

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