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Understanding Retirement Savings: 401(k) vs. IRA
Two of the most common ways to save and invest for retirement are individual retirement accounts (IRAs) and 401(k) plans. Both of these retirement tools are readily available, easy to set up, and offer significant tax advantages. However, when comparing IRAs and 401(k)s, some key differences emerge. Although both types of accounts are designed for retirement, 401(k)s have higher contribution limits and are available as employee benefits, while IRAs have lower contribution limits but are available to anyone—employed, self-employed, or otherwise. Here’s how these two types of accounts stack up.
What Is a 401(k)?
Some employers offer tax-advantaged 401(k) plans as a benefit to their employees. Under a traditional 401(k) plan, you can arrange to have a portion of each paycheck automatically directed to retirement savings. These elective deferrals are excluded from your gross pay, which reduces your taxable income. You won’t pay income taxes on earnings while your money grows in your account. However, you will pay income taxes on the money you withdraw when you retire.
Employer Matching
Some employers match your 401(k) contributions as an added benefit. Matching funds are usually capped at a percentage of your earnings (for example, 3%). Some employers match your contribution dollar-for-dollar; others provide a partial match—for instance, 50 cents on the dollar.
Say your employer offers to match 100% of your contributions up to 3% of your salary. You earn $60,000 a year. To maximize your matching dollars, you contribute 3% (or $1,800) to your 401(k), and your employer matches you with an additional $1,800. In this scenario, you pay in $1,800 but end the year with $3,600 in total contributions, effectively doubling your money.
Vesting
Depending on your employer’s policy, you may lose a portion of your contributions or employer matching funds if you leave your job before you’re fully vested. Vesting rules vary: Some plans vest an employee immediately, some do so gradually, and others vest fully after several years.
Contribution Limits
For the 2023 tax year, you can contribute up to $22,500 to a 401(k) plan. If you’re age 50 or older, you can contribute an additional $7,500 for a total contribution of $30,000. These contribution limits do not include employer matching dollars. Your total contributions, including employer matching, can’t exceed 100% of your compensation or $66,000 for 2023.
Early Withdrawals
You can begin withdrawing money from your 401(k) plan starting at age 59½. If your plan allows you to make early withdrawals (not all do), the IRS assesses a 10% early withdrawal penalty in addition to regular income taxes on the distribution amount. Exceptions to the 10% penalty may apply in cases of financial hardship.
What Is an IRA?
IRAs aren’t linked to your employment. Anyone who has taxable compensation can open and fund their own IRA independently. IRAs are widely available from banks, credit unions, brokerages, and mutual fund companies.
Types of IRAs
Although all IRAs are geared toward tax-advantaged retirement savings, there are different types of IRAs:
- Traditional IRAs: Allow you to exclude your contributions from your taxable income. You won’t pay taxes on your money as it grows, but you will pay taxes on it when you withdraw it in retirement.
- Roth IRAs: Funded with after-tax dollars (no tax deduction), but money grows tax-free while it’s in your account and isn’t taxed when you withdraw it in retirement.
- Spousal IRAs: Allow non-working spouses to contribute to their retirement even if they don’t have qualifying taxable income.
- Rollover IRAs: For funds rolled over from past 401(k)s and IRAs.
- SEP IRAs: Allow business owners to contribute to both their employees’ and their own retirement savings. Only employers may contribute.
- SIMPLE IRAs: Allow elective contributions from employees, similar to a 401(k).
Contribution Limits
The IRS limits the amount of money you can put into an IRA each year. Like 401(k) contribution limits, IRA contribution limits are indexed to inflation and may change from year to year. For 2023, the IRA contribution limit is $6,500 with an additional $1,000 catch-up contribution for people age 50 or older. Your IRA contribution can’t be greater than your income.
Early Withdrawals
A 10% early withdrawal penalty and regular income taxes apply if you withdraw funds from a traditional IRA before you reach age 59½, unless you meet an exception. You can withdraw the contributions you’ve made to a Roth IRA at any time without penalty, but you’ll pay a 10% penalty and income taxes on any earnings you withdraw early.
Key Differences Between IRAs and 401(k)s
Sorting out the differences between IRAs and 401(k)s can seem complicated. Here are some key differences, shown side-by-side:
| 401(k) | IRA |
|---|---|
| Must be eligible according to your employer’s plan policies | Available to anyone with taxable compensation |
| For 2023, $22,500 ($30,000 if age 50 or older) | For 2023, $6,500 ($7,500 if age 50 or older) |
| Your employer may match (or partially match) your contributions | Matching doesn’t apply |
| Roll funds over into a new employer’s 401(k) or a rollover IRA | Funds stay in your account until you withdraw them or move accounts |
| May require a vesting period before funds are fully yours | Funds are not subject to vesting |
| 10% penalty on withdrawals made before age 59½ (unless an exception applies) | 10% penalty on withdrawals made before age 59½ (unless an exception applies) |
| Plan may allow you to borrow up to 50% of your account’s value, or a maximum of $50,000, from your 401(k) in lieu of withdrawing money | Loans against IRAs are not allowed |
| Required minimum distributions must be taken from a 401(k) starting at around age 73 | Required minimum distributions must be taken from a traditional IRA starting around age 73. No required minimum distributions for Roth IRAs |
| Some employers offer Roth 401(k)s. Check with your plan administrator. | Roth IRAs are a ready alternative to traditional IRAs. You can also convert a traditional IRA to a Roth. |
How to Choose Between an IRA and a 401(k)
Both 401(k) plans and IRAs are essential tools when you’re saving for retirement. Both are widely available and offer tax advantages that can help you maximize your savings over time.
When to Choose a 401(k)
If your employer offers a 401(k) plan, it’s probably worth considering. Elective deferrals taken out of your paycheck make it easy to invest regularly. Matching funds provide an immediate return on your investment, though you may have to wait to become fully vested before all of your funds are yours. Higher contribution limits mean it’s possible to sock away money at a healthy clip.
When to Choose an IRA
An IRA is a great alternative when a 401(k) plan isn’t available to you, for instance because you’re self-employed or a non-working spouse. IRAs are easy to open: You can establish an IRA or Roth IRA at most banks, credit unions, mutual fund companies, or investment brokerages. An IRA is also a simple option if you have a lump sum to contribute.
Why Not Choose Both?
If you have enough money to invest, you may want to contribute to both a 401(k) and an IRA. The IRS has income limits that may affect your ability to make a Roth IRA contribution or deduct a traditional IRA contribution when you or your spouse also contribute to a workplace retirement plan. But as long as you’re eligible, you might consider contributing to both types of accounts if you’ve maxed out your 401(k) contributions (or employer match), or if you’re interested in options that aren’t available through your employer’s 401(k)—for example, a Roth account.
Maintaining both a 401(k) and an IRA requires a bit more brain power: You’ll have multiple accounts to track. But, if you have the funds, contributing to both a 401(k) and an IRA lets you maximize your tax-advantaged savings.
The Bottom Line
Saving for retirement is a marathon, not a sprint. Using tax-advantaged accounts like 401(k)s and IRAs can help you maintain your pace as you build your nest egg over time. Participating in your employer’s 401(k) plan can help you save consistently and take advantage of matching funds. Opening and funding a traditional or Roth IRA gives you an additional opportunity to save—and save money on taxes. Either type of account can help you meet your retirement goals. Over the long haul, if you’re serious about saving for retirement, you may want both.
For any mortgage-related needs, feel free to call O1ne Mortgage at 213-732-3074. We’re here to help you navigate your financial future with confidence.
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