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Employer pension plans are a thing of the past. This means saving for retirement is a must, today more than ever before.
Saving in any retirement plan is better than not saving at all. But you need to know your options to navigate your retirement savings plans effectively.
There are a few differences to consider when deciding the best strategy for you.
In this article, we'll cover the differences between the two most common retirement savings tools, the Individual Retirement Account (IRA) and the 401(k). Then we'll dive into where to invest first, based on your available options.
What’s the Difference Between an IRA and a 401(k)?
Individual Retirement Accounts (IRAs) and 401(k)’s are both tax-advantaged retirement plans. But there are some basic differences and limitations to consider with each type of plan.
401(k)
A 401(k) is a retirement plan offered by employers. Though not all employers provide 401(k)’s as an employee benefit, many do.
Note: Self-employed individuals may be eligible for a Solo 401(k).
Your 401(k) plan contributions are taken directly out of your paycheck. And the money you contribute to a 401(k) plan is pre-tax money.
So, funding a traditional 401(k) plan reduces your taxable income by the amount you contribute.
More and more employers are also offering a Roth 401(k).
Contributions to a Roth are made with after-tax funds. While you won’t reduce your taxable income by contributing to a Roth, you will not owe taxes when you make a qualified withdrawal from it down the road.
Some employers also offer a 401(k) company match. This means the company matches a percentage of the amount you put into your 401(k).
The company match goes to your 401(k) plan tax-free and does not count toward your maximum annual contribution. Company matches are free money.
More about 401(k)s:
- Some 401(k) plans allow you to borrow money from your 401(k) plan. Before you do this, learn about repayment and what happens if you leave your job.
- If you leave your job, you can no longer contribute to that employer’s 401(k) plan (you can roll it over into an IRA or your new employer’s 401(k) plan.)
[Some employers may offer a similar type of retirement savings plan, such as a 403(b), 457(b), SEP, or SIMPLE IRA. Check your employer benefits or contact human resources for this information.]
Individual Retirement Accounts (IRAs)
An IRA is a retirement savings plan you open yourself through a financial institution. Like 401(k)’s, IRAs are tax-advantaged.
The maximum annual contribution to an IRA is much lower than a 401(k). Yet, IRAs allow you to have more control over investment selections and management fees.
Traditional IRAs versus Roth IRAs
Traditional and Roth IRAs are both tax-advantaged retirement plans. But there are differences between these types of IRAs to consider when saving for retirement.
A traditional IRA gives you an immediate tax break. Your contributions to a traditional IRA use pre-tax money. But withdrawals are taxed as regular income (after the age of 59½).
If you also contribute to your employer’s 401(k), your tax break on a traditional IRA can be limited by your income.
A Roth IRA gives you a deferred tax break. Your contributions to a Roth IRA use after-tax money, and withdrawals are tax-free (after the age of 59½).
Your participation in your employer’s 401(k) plan doesn’t affect a Roth IRA. But you should be aware of the Roth IRA income limits.
401(k)s Vs. IRAs – The Key Differences
Both 401(k)s and IRAs are tax advantaged and have tax-deferred growth. Still, there are many differences to be aware of when deciding on the best retirement savings strategy.
Eligibility
- 401(k): You must work for a company that sponsors a 401(k) plan to participate.
- Traditional IRA: Anyone with earned income is eligible (though tax benefits vary).
- Roth IRA: Anyone with earned income within the income limits can take part.
Contribution Restrictions
IRA contribution limits are significantly lower than 401(k) contribution limits.
- 401(k): The 2022 contribution limit is $20,500 (2021 – $19,500) annually (if you’re over 50, it’s $27,000).
- IRAs (traditional and Roth): The 2022 contribution limit is $6,000 annually (if you’re over 50, it’s $7,000).
Tax Advantages of Contributions
- 401(k): Contributions are not subject to income tax (up to the annual contribution limit).
- Traditional IRA: Contributions may be tax-deductible – depending on your income and if you have a 401(k) plan through work.
- Roth IRA: Contributions use after-tax dollars (not tax-deductible).
Employer matches
- 401(k): Many employers with 401(k) plans offer a match on the percentage of income employees contribute to their plans.
- IRAs: No employer matches are available since these accounts are independent of employer benefits.
Withdrawals: Tax benefits and RMDs
- 401(k): You pay income tax on your withdrawals (unless they’re in a Roth 401(k)*). Withdrawals made before the age of 59½ are also subject to a 10% penalty. 401(k)’s are subject to Required Minimum Distributions (RMDs) after age 72.
- Traditional IRA: Like a 401(k), you pay income tax on your withdrawals. Withdrawals made before the age of 59½ are also subject to a 10% penalty. IRAs are subject to Required Minimum Distributions (RMDs) after age 72.
- Roth IRA: Withdrawals on your contributions are tax and penalty-free (after a 5-year holding period). Withdrawals on growth, made before the age of 59½, are subject to a 10% penalty. Yet, there are exceptions for college and home-buying expenses. Roth IRAs do not have Required Minimum Distributions (RMDs) after age 72.
Investment options
- 401(k): Investments are limited to what’s offered by the employer and management companies.
- Traditional and Roth IRAs: You have more control and investment choices. You can choose the company in which to open your IRA account. Most brokerage companies offer a wider variety of investments than 401(k) plans.
- Learn more about a Self-Directed IRA which offers additional investment options
Management fees
- 401(k): Most 401(k) plans have management fees (some are higher than others).
- IRAs: Management fees for IRAs are often less than those for 401(k)’s.
TLDR: What’s Best for You – an IRA, a 401(k), or Both?
The great thing is it may be possible to use both types of plans to save for your retirement.
Each plan has contribution limits, and IRAs have income restrictions. Still, many individuals qualify for both IRAs and 401(k)’s for their retirement savings.
To take a balanced approach to current and future taxation, you could invest in both a 401(k) and Roth IRA (or Roth 401(k), if it’s available).
You might make an educated guess on your income taxes in retirement and lean toward one side or the other.
For example, if you make more money today than you expect to make in retirement, you might focus on the immediate tax advantages with a 401(k) and/or traditional IRA.
If you plan to make more money in retirement, you might lean more toward the Roth option now to save on taxes later.
Should You Invest in Your 401(k) or IRA First?
The answer depends on your circ*mstances and what options are available to you. Read on to see what the best option is for you.
Does your employer offer a 401(k) match?
1. If the answer is yes, first contribute enough to your 401(k) to get your employer’s match. It’s best to tap into this extra, free money first.
For example, let’s say your employer offers a 6% match. When you save 6% of your income in your 401(k) plan, your employer will also contribute that same amount to your 401(k) plan. (Your employer match does not count toward your maximum contribution.)
2. After you contribute enough to your 401(k) to get the employer match, fund an IRA (up to the contribution limit).
Whether you use a traditional or Roth IRA will depend on whether you want a tax break now or later. Also, it will depend on where you fall in the limits and restrictions for IRAs.
3. After you get your company 401(k) match and max out your IRA, you can go back and invest more in your 401(k). Even though 401(k)s have their limitations, the tax advantages make them well worth it.
Does your employer offer a 401(k), but not a 401(k) match?
1. First, fund a traditional or Roth IRA (or both), up to the maximum amount. IRAs give you more investment options than your 401(k), giving you more control over your investments. Plus, fees are generally lower with IRAs.
2. After you max out your IRA contributions, fund your 401(k) to take advantage of the pre-tax retirement savings.
What if your employer doesn’t offer a 401(k) plan?
1. If you don’t have access to a 401(k) benefit (or similar plan) through your employer, fund a Roth IRA or traditional IRA.
2. After you contribute the max to your IRA, consider saving more in a taxable brokerage account.
What if you own a small business or are an independent contractor?
In this case, you have several options that are equally beneficial.
The easiest way to save is to open a Roth or traditional IRA.
But when you’re self-employed, you can also fund a solo 401(k) or SEP IRA. Both have higher contribution limits than those offered by an employer.
Choose the Method You’ll Actually Use
The order in which you invest does make a difference, but the most important thing is to choose a plan that works for you.
Whether you invest in a 401(k), IRA, or both, will depend on your circ*mstances. Still, the most important thing is that you’re investing consistently.
Some individuals find their 401(k) is the easiest way to save for retirement, with or without a match. 401(k)’s offer limited investment choices, making decision making less time-consuming.
Also, contributions come right out of the paycheck, making it even easier to save.
Others find IRA’s to be easier since you have more control over your investment options.
Final Thoughts on IRAs vs. 401(k)'s
No matter which route you decide to take, if you’re investing in a retirement plan, you’re on the right path to a financially secure future.
Both 401(k)’s and IRAs offer significant tax advantages. And the fact that you’re investing for the long-term puts you in a much better financial situation later in life.
Next: Pay Down Debt First or Start Investing?
Article written by Amanda, a team member of Women Who Money and the founder and blogger behind Why We Money where she enjoys writing about happiness, values, and personal finances.
