401(k) vs. IRA: Which Should You Choose?

Properly funding a future retirement is no passive feat. It requires commitment to a savings strategy over many years, and can involve a number of different investment approaches. To aid in those efforts, there are a few different tax-advantaged savings accounts available to investors today. 

Two of the most common are the 401(k) and the IRA, both of which offer certain benefits to investors that can make those retirement savings goals more attainable. Here’s a look at the rules associated with each type of account, their limitations, and how to choose the most suitable one.

What is a 401k?

A 401(k) is an employer-sponsored retirement savings plan. It allows employees to direct a portion of their earnings into the account and defer paying income tax on it until they withdraw it in retirement. These dollars can then be invested into any number of funds chosen by the account sponsor (their employer). Contributions are automatically deducted from employees’ paychecks, at whatever rate the employee selects.

With a traditional 401(k) plan, contributions are made with pretax dollars. Any qualifying funds contributed to a 401(k) plan throughout the year can be deducted, reducing one’s total taxable income for that year. There are also Roth 401(k)s—which are funded with after-tax dollars and may be withdrawn tax-free—but not all employers offer one.

Employers may also choose to match some or all of their employees’ contributions to their 401(k), in what is known as an employer match.

When an employee leaves the company, they can choose to rollover their 401(k) funds into a new employer’s 401(k) or into an individual retirement account (IRA).

Advantages of 401(k) plans

401(k) plans entail several key benefits for investors.

1. Tax-advantaged savings.

   With a traditional 401(k), investors can deduct contributions from their taxable income that year. With a Roth 401(k), investors make contributions with after-tax dollars and make tax-free withdrawals in retirement.

2. Set it and forget it.

   Employees usually elect how much money they want to defer from their salary to a 401(k) once during the calendar year. Once the amount is set, the savings are allocated from their paycheck to their retirement account automatically.

3. Funds accessible via loan.

   Some 401(k) plans allow for loans against the account balance prior to retirement. While the loan will need to be repaid and incurs both interest and fees, this can offer another safety net for account owners who need to access the funds earlier than age 59½.

4. Potential employer match.

   Some employers offer to match contributions to 401(k) accounts. So every time an investor contributes to their account, their employer may match some or all of those dollars, up to a maximum amount each year. Every dollar an employer matches is free money toward retirement.

Drawbacks of 401(k) plans

The specifications of a 401(k) plan is determined by the employer, which can create downsides or limitations for the employee.

• Eligibility.

  An employer can set eligibility requirements for participation in their 401(k) plan. These can be based on how long an individual has worked for the company, how many hours a year they work, and even their age.

• Limitations to matching.

  The employer may not offer to match contributions, or if they do, might subject them to a vesting schedule.

• Lack of choice in investment options.

  Employees must also choose between the funds offered by their employer, and these investment options may come with high fees.

Maximum contributions

For 2022, eligible employees can contribute up to $22,500 toward their 401(k) savings plan. If they’re over 50, a catch-up contribution of $6,500 is allowed, bringing the total maximum contribution to $29,000.

How to open a 401k

If a workplace offers a 401(k), the company’s benefits coordinator can explain their investment options and help set up the account. Self-employed individuals can opt for a Solo 401(k) for themselves or both them and their spouse. Opening a Solo 401(k) can be done through most online brokerages.

What is an individual retirement account (IRA)?

Another retirement savings plan option is the individual retirement account, or IRA. An IRA can come in a few different varieties, offering tax advantages either at contribution or at distribution. These accounts are available through a variety of financial institutions including banks, credit unions, and online brokerages.

Traditional IRA

A traditional IRA is a tax-deferred retirement savings vehicle. Contributions are made with pretax funds, similar to a 401(k). When distributions are taken in retirement, they are taxed as ordinary income.

Distributions cannot be taken before age 59½ without triggering taxes and a 10% penalty. Required minimum distributions for traditional IRAs also begin at age 72. If an investor fails to take these distributions, there is a penalty equal to 50% of the undistributed amount.

The maximum annual contribution to a traditional IRA is $6,000 for 2022 (or $7,000 for those 50 or older). Tax-deductible contributions are allowed up to that maximum, but begin to phase out depending on one’s AGI for the year.

Roth IRA

With a Roth IRA, contributions are made with after-tax dollars, but when distributions are taken out in retirement, they are tax-free (including any growth).

Since Roth IRA contributions are made with taxed dollars, the contributions can be withdrawn at any time without penalty. Withdrawing gains, however, will trigger both taxes and a 10% early withdrawal penalty fee if they’re taken prior to age 59½ or less than five years after the account was opened. There are no RMDs with a Roth IRA as long as the account owner is alive.

As with traditional IRAs

, the maximum contribution to a Roth IRA is currently limited to $6,000 per year ($7,000 if over age 50).

SEP IRA

A simplified employee pension IRA, or SEP IRA, is for small business owners, their employees, or self-employed individuals. Contributions are made with pretax dollars, so distributions in retirement are taxed as ordinary income.

Maximum annual contributions are currently the greater of $61,000 or 25% of one’s annual compensation. Withdrawals can be taken as early as 59½ without penalty, and RMDs are required starting at age 72.

Advantages of IRAs

IRAs offer individuals the ability to save for retirement in a tax-advantaged account that’s not tied to an employer.

• Tax-advantaged savings.

  An IRA offers tax advantages to future retirees either at the time of contribution or when it’s time to take distributions from the account, depending on the type of IRA.

• Flexibility and choice.

  Account holders can also choose their investments. Since traditional and Roth IRAs aren’t managed by employers, account owners can choose the institution and specific securities or assets, be they mutual funds, exchange-traded funds, stocks, or bonds. IRAs can even be used to invest in real estate.

Drawbacks of IRAs

Investors should be aware of the stipulations and limitations of IRAs before investing.

• Low contribution limit.

  In 2022, employees can contribute as much as $6,000 per year into a traditional or Roth IRA. For those ages 50 and older, a catch-up contribution of $1,000 is allowed, bringing the maximum to $7,000. The exception is the SEP IRA, which allows for up to $61,000 in annual contributions.

• Stiff penalties and few exceptions.

  Once these contributions are made, the money is essentially locked away until retirement. There are exceptions, but they’re tied to true necessity. IRAs do not allow loans like 401(k)s.

• Income limits.

  Some IRAs also set maximum income limits for eligibility. Those who surpass certain thresholds either cannot contribute or deduct their contributions at tax time.

• No employer match.

  Only some types of IRAs—like an SEP—allow for employer contributions. In most cases, only the employee can contribute to their IRA, which limits employer matching.
  

How to open an IRA

An IRA can be opened at many different banks, credit unions, and brokerages including online platforms and robo-advisors.

Once an individual has chosen where to open an IRA, they’ll need to provide personal information like their name, date of birth, address, and Social Security number. They may also need to provide a copy of a government-issued ID like their passport or state driver’s license as well as their phone number or email address.

The individual will need to choose the type of IRA they want to open and name a beneficiary. The institution will want to know how they plan to fund the account and make contributions (including amounts). If funding with another bank account, the individual will be asked to link these accounts.

Rolling funds from another IRA or 401(k) will require additional paperwork.

401k vs. IRA: What are the main differences?

So, what’s the difference between a 401(k) and an IRA? Here are some of the biggest:

• IRAs do not allow loans, while 401(k) accounts do (with interest and fees).
• 401(k)s have larger contribution limits than traditional and Roth IRAs.
• With a 401(k), the employer selects the funds; with an IRA, employees have more control over the institution and investments.

What to consider when deciding a 401(k) and IRA

When determining whether to open and contribute to an IRA or a 401(k), there are a few questions to consider. Here are some to start:

• How much do I plan to contribute this year?

  Traditional and Roth IRAs have lower contribution limits than 401(k)s.

• Does my employer offer a contribution match?

  If an employer offers to match 401(k) contributions, that’s free money for retirement savings. ‍

• What will my income look like in retirement?

  With a traditional IRA, an investor pays income tax on their retirement funds when they’re withdrawn. The tax rate is based on their total income in retirement, which could be higher, lower, or the same as the year in which they contributed the funds. With a Roth IRA, an investor pays income tax, at their current tax rate, on the funds in the year they’re contributed. They withdraw them tax-free in retirement.

Can you have both an IRA and a 401k?

Investors can contribute to both types of accounts throughout the year and both can play an important role in their retirement savings strategy. The amount an investor can contribute to an IRA and/or deduct from their taxes may be governed by income limits, especially if they also participate in a workplace retirement savings plan like a 401(k).

The bottom line

Both IRAs and 401(k)s have tax benefits and drawbacks for future retirees. There are some important distinctions to make between the two account types, so investors can consider their options and how each account type would impact their retirement savings strategy. Those who can’t decide can hold and contribute to both types of accounts at the same time.