401(k) vs. IRA: An Overview
The two main options for saving for retirement include 401(k) plans and individual retirement accounts (IRAs). When employers want to give their employees a tax-advantaged way to save for retirement, they may offer participation in a defined-contribution plan such as a 401(k).
Employees typically contribute a percentage of their salary to their 401(k), while the employer may offer matching contributions up to a specific limit. Employers might also offer a simplified employee pension (SEP) IRA, or a Savings Incentive Match Plan for Employees (SIMPLE) IRA if the company has 100 or fewer employees.
Individuals can opt to save on their own and open an IRA (an individual can have both a 401(k) and an IRA). But, IRAs don’t provide matching contributions from an employer. Various types of IRAs have specific income and contribution limits, as well as specific tax advantages. Both traditional IRAs and 401(k)s are tax-deferred, taxes are deferred until the funds are withdrawn.
Most IRAs and 401(k)s do not allow withdrawals before the owner reaches the age of 59½. Any money taken out before that age incurs a tax penalty by the Internal Revenue Service (IRS). There can be exceptions to the early withdrawal penalty depending on the specific retirement account and a person’s financial situation
Key Takeaways
- 401(k) plans are tax-deferred retirement savings accounts.
- Employers offer 401(k)s and may match an employee’s contributions.
- Individuals can also set up a traditional IRA or Roth IRA, which does not have employer matching.
- IRAs generally offer more investment choices than 401(k)s, but permitted contribution levels are much lower.
- SEP and SIMPLE IRAs were designed to make it easy for employers to set up retirement plans for employees.
401(k)s
A 401(k) is a tax-deferred retirement savings account employers offer their employees. Employees may contribute money to their account via elective salary deferrals, meaning a percentage of their salary is withheld and contributed to the 401(k).
The money is deposited in various investments, typically a lineup of mutual funds, as selected by the sponsor. The fund choices are designed to meet a specific risk tolerance so that employees may only take on as aggressive or conservative a risk as they are comfortable with taking. Investment income accrues and compounds tax-deferred.
Many employers are also offering Roth 401(k)s. Unlike a traditional 401(k), contributions are funded with after-tax money, so they are not tax-deductible. Withdrawals are taxed at the person’s income tax rate, and there’s no penalty for withdrawals as long as the distributions are made at age 59½ or older. Qualified withdrawals, though, are tax-free. These include hardship withdrawals or those made for medical reasons, among others.
Employee Contributions
Contributions to 401(k) accounts are made pretax, meaning the total of the contributions would reduce your taxable income for that year by the contribution amount. For example, if an employee earned a $50,000 salary and contributed $10,000 to a 401(k), then the taxable income for the year would be $40,000—all else being equal.
For 2023, participants can contribute up to $22,500 per year to a traditional or Roth 401(k), with an additional $7,500 catch-up contribution allowed for people ages 50 and older. The contribution limit increases to $23,000 in 2024. The catch-up contribution, though, remains the same at $7,500.
Employer Matching Contributions
Employers typically match a percentage of their employee's contributions up to a certain limit or percentage. An employer might match based on how much the employee contributes annually. For example, an employer could match 50% of an employee’s contribution up to 6% of their salary. If an employee contributes 6% of their salary, then the employer will contribute a 3% match.
In some cases, employers may simply state a matching policy that is effective up to but not over IRS limitations. For example, a company may state it will make a 50% match on all 401(k) contributions up to contribution limits. In this case, a company may match up to $11,250 in 2023 (50% of $22,500).
If the employee doesn’t contribute the full 6%, they might not qualify for a match and receive either nothing or a reduced portion from the employer. To receive the employer match, the employee may need to contribute a minimum amount or percentage of their salary. It’s important to review the 401(k) retirement plan documents to determine if there’s an employer match, and if so, what the maximum match and the minimum employee contribution are to qualify for a matching contribution.
The IRS has established limits on total contributions—by both employee and employer—to a 401(k). Total contributions may not exceed $66,000 or $73,500 with catch-up contributions in 2023. These amounts increase to $69,000 or $76,500 with catch-up contributions in 2024. Alternatively, the total contribution to a 401(k) cannot exceed 100% of the participant's compensation.
IRA Benefits
Employer plans typically provide some amount of matching contribution. You get to select from a menu of mutual funds or exchange-traded funds (ETFs), as outlined by your plan. An IRA is not tied to an employer. If your income is below a certain amount and you are not covered by an employer plan, then you can contribute up to $6,500 in 2023 ($7,000 in 2024) plus a $1,000 catch-up contribution for those ages 50 and over.
Individual Retirement Accounts (IRAs)
An IRA can be as straightforward as a savings account or certificate of deposit (CD) at a local bank. IRAs held by brokerage and investment firms offer IRA owners more investment options than 401(k)s, including stocks, bonds, CDs, and even real estate. Some assets, such as art, are not permitted within an IRA, according to IRS rules.
Like 401(k)s, contributions to traditional IRAs are generally tax-deductible. Earnings and returns grow tax-free, and you pay tax on withdrawals in retirement. Contributions to a Roth IRA are made with after-tax dollars, meaning you don’t receive a tax deduction in the year of the contribution; however, qualified distributions from a Roth IRA are tax-free in retirement.
As with 401(k) plans, IRA holders can begin withdrawals after they reach age 59½. Withdrawals before that age will incur a 10% tax penalty unless you qualify for a hardship withdrawal. Importantly, unlike 401(k) plans, the IRS does not allow you to borrow against the balance of your IRA account.
"The benefit of an IRA is that your investment choices are much greater and almost unlimited," according to Michelle Mabry, certified financial planner, Client 1st Advisory Group, Hattiesburg, Mississippi. "The costs of each need to be considered, and they will vary depending on the investment selection."
IRA Contribution Limits
Annual contribution limits are capped for IRAs just like they are for 401(k) plans. The contribution limits for traditional and Roth IRAs are $6,500 for 2023 with an additional $1,000 catch-up contribution allowed for people ages 50 and older. This limit increases to $7,000 in 2024. With the additional $1,000 catch-up contribution, people 50 and over can contribute a total of $8,000 to an IRA in 2024.
There are several types of IRAs, which are tax-advantaged retirement savings accounts established by an individual. IRAs can be held by banks, brokerages, and investment firms.
Key Differences
The primary differences between 401(k) plans and individual retirement accounts are explained in the following table:
| IRAs vs. 401(k) Plans: 2023 Limits and Policies | ||
|---|---|---|
| 401(k) Plan | Individual Retirement Account | |
| Annual Contribution Limits (if younger than 50) | $22,500 | $6,500 |
| Catch-up Contribution Limits (if older than 50) | $7,500 (for total of $30,000) | $1,000 (for total of $7,500) |
| Contribution Source | Contributions automatically deducted from paycheck. Employer may match contributions. | Account owners must fund their own accounts. |
| Choice of Assets | A few funds chosen by the plan administrator | A wide universe of stocks, mutual funds, index funds, and other assets. |
| Creation | Set up by employers | Set up by account holders. |
| Types of Accounts | Roth and traditional 401(k) | Traditional, Roth, SET, and SIMPLE IRAs. |
| Required Minimum Distributions | Start in the year you reach 73 or 75 depending on the year you were born. | Start in the year you reach 73 or 75 depending on the year you were born. (Roth IRAs are not subject to required minimum distributions.) |
| IRAs vs. 401(k) Plans: 2024 Limits and Policies | ||
|---|---|---|
| 401(k) Plan | Individual Retirement Account | |
| Annual Contribution Limits (if younger than 50) | $23,000 | $7,000 |
| Catch-up Contribution Limits (if older than 50) | $7,500 (for total of $30,500) | $1,000 (for total of $8,000) |
| Contribution Source | Contributions automatically deducted from paycheck. Employer may match contributions. | Account owners must fund their own accounts. |
| Choice of Assets | A few funds chosen by the plan administrator | A wide universe of stocks, mutual funds, index funds, and other assets. |
| Creation | Set up by employers | Set up by account holders. |
| Types of Accounts | Roth and traditional 401(k) | Traditional, Roth, SET, and SIMPLE IRAs. |
| Required Minimum Distributions | Start in the year you reach 73 or 75 depending on the year you were born. | Start in the year you reach 73 or 75 depending on the year you were born. (Roth IRAs are not subject to required minimum distributions.) |
SEP and SIMPLE IRAs
SEP and SIMPLE IRAs are offered by employers to their employees and are similar to 401(k) accounts in many ways, but there are some differences—their contribution limits are chief among them.
SEP and SIMPLE IRAs were designed to make it easy for employers to set up a retirement plan for employees. They have fewer administrative burdens than 401(k) plans. For the self-employed, the term employer includes an owner/employee.
SEP IRAs
SEP IRAs have higher annual contribution limits than standard IRAs, and only your employer can contribute to them. Employer contributions can be as much as 25% of an employee’s gross annual salary as long as they don't exceed a certain amount.
The annual contribution limit is $66,000 or $73,500 for those 50 and older in 2023. These amounts increase to $69,000 or $76,500 with the catch-up contribution in 2024.
Many 401(k)s have vesting requirements for matching contributions, but SEP and SIMPLE IRAs are 100% vested as soon as a contribution is made.
SIMPLE IRAs
SIMPLE IRA contributions work differently than SEP IRAs and 401(k)s. An employer can either match up to 3% of an employee’s annual contribution or set up a nonelective 2% contribution of each employee’s salary. The latter doesn’t require employee contributions.
The contribution limit for employees is $15,500 in 2023 and $16,000 in 2024. People 50 and over can make an additional catch-up contribution of up to $3,500 in both 2023 and 2024.
Is It Better to Have a 401(k) or an IRA?
Whether a 401(k) or an IRA is better for an individual depends on the individual. A 401(k) allows for more money to be contributed each year on a pretax basis than an IRA. One benefit to IRAs is that they tend to have more investment options, which allows for greater control and flexibility over the account. Note that an individual can have both.
Is a 401(k) an IRA?
Both accounts are retirement savings vehicles, but a 401(k) is a type of employer-sponsored plan with its own set of rules. A traditional IRA, on the other hand, is an account that the owner establishes without an employer's involvement.
Is a 401(k) Considered an IRA for Tax Purposes?
Not all retirement accounts have the same tax treatment. There are different tax benefits for IRAs and 401(k)s. Roth IRAs don’t offer a tax deduction for contributions, but withdrawals are tax-free in retirement. Traditional IRAs offer a tax deduction, while 401(k)s allow pre-tax income to be deposited, which reduces taxable income in the year of the contribution. Distributions in retirement from 401(k)s and IRAs are considered taxable income.
Can You Lose Money in an IRA?
Yes. IRA money held by a brokerage or investment firm is usually invested in securities such as mutual funds or stocks, which fluctuate in value. Note that an IRA is no more or less likely to decline in value than any other investment account. The owner of an IRA faces the same market risks as the account holder of a 401(k).
Can You Roll a 401(k) Into an IRA Penalty-Free?
The IRS allows for a rollover or transfer of your funds from a 401(k) to an IRA; however, the process and guidelines outlined by the IRS must be followed so that the IRA transfer doesn’t count as a distribution, which could incur a penalty. The easiest way to make sure funds roll over penalty-free is to do a direct rollover.
The Bottom Line
IRAs and 401(k) plans are both great investing tools with different strengths. Because a 401(k) is an employer-sponsored plan, you may have less ability to choose your investments, but your contribution limits are much higher than in a traditional or a Roth IRA. Ideally, you can use the two accounts together to create a comprehensive portfolio so you can relax and enjoy your retirement.
