IRAs and 401(k)s compared

As the cost of living rises, corporate pensions disappear and people live longer, it’s more apparent than ever that you need to save for retirement.

But what’s the best way to set aside money for your golden years?

Retirement savings accounts are a solid option for most investors thanks to their tax benefits. There’s a wide range of these accounts to choose from, but traditional 401(k)s and individual retirement accounts (IRAs) are two of the most popular.

As you begin to choose which type of account to open, it’s important to understand the differences between 401(k)s and IRAs and the pros and cons of each.

Understanding retirement savings plans

Retirement savings plans like 401(k)s and IRAs encourage investors to save early and regularly.

“Time is the ‘secret sauce’ to investing,” said Anna Sergunina, president and CEO at MainStreet Financial Planning, a financial planning firm. “The more time you have, the longer you allow your money to grow for you.”

But whether you’re decades away from retirement or that next stage of life is right around the corner, these tax-advantaged retirement savings accounts can help you meet your goals.

What is a 401(k)?

A 401(k) is an employer-sponsored retirement savings plan that many companies offer as a part of their benefits package. With one of these accounts, you can opt to have a certain amount of your paycheck automatically put toward your retirement. Your employer, in turn, will typically match your contributions up to a certain point.

The money you put into a 401(k) is invested in a variety of securities like stocks, bonds and funds. Target-date funds — pooled investments with a specific investment horizon tied to the recipient’s planned retirement date — are popular options for 401(k) plans because they hold more conservative investments the closer you get to retirement.

Two popular types of 401(k) plans are the traditional 401(k) and the Roth 401(k), which many employers have started to offer in recent years. Unlike a traditional 401(k), in which contributions are made tax-free and distributions are taxed in retirement, a Roth 401(k) allows you to make post-tax contributions and withdraw your money tax-free.

What is an IRA?

While a 401(k) is offered by an employer, an IRA is an account you open on your own. Two common types of IRAs are the traditional IRA and the Roth IRA. The main difference between the two comes down to their tax treatment.

With a traditional IRA, investors don’t pay taxes on their contributions until they withdraw the money later in life. A Roth IRA is the opposite: Investors make after-tax contributions now and withdraw their money tax-free in retirement.

IRA versus 401(k): Key differences between savings plans

While both can be successful tools when it comes to retirement savings, IRAs and 401(k)s are different vehicles — and you must understand how each works before you invest.

Employer match

When you invest in an IRA, you’re investing on your own, so there is no match from an employer. But when you invest in a 401(k), your employer may, either partially or fully, match your contribution up to a certain amount.

For example, if your employer offers a 100% match on your contributions up to 5% of your paycheck, you’ll get a maximum contribution from your employer of 5% of your annual salary as long as you contribute at least 5% of your annual salary yourself. But if you contribute 10%, you’ll still only get a 5% match from your employer if that’s their upper limit.

Here’s what this type of employer match would look like at various contribution levels, assuming a $50,000 salary:

What a 401(k) employer match means for you

Not contributing the maximum your employer will match is essentially saying goodbye to free money.

“Always make sure you contribute up to the match that your employer offers because you do not want to leave money on the table,” said Anjali Jariwala, the founder of financial planning firm FIT Advisors.

IRA and 401(k) contribution limits

While investing is crucial to securing a comfortable retirement, make sure you don’t exceed the contribution limits for your retirement accounts set by the Internal Revenue Service (IRS).

In 2023, the most savers under age 50 could contribute to an IRA was $6,500, or $7,500 for those 50 and older. For the 2024 tax year, those contribution limits increased to $7,000 if you’re not yet age 50, or $8,000 if you’re age 50 or older. That is the total you can put in all your traditional IRAs and Roth IRAs — you can’t contribute $7,000 to a traditional IRA and then do the same in a Roth IRA.

The limit is much higher for a 401(k): $23,000 in 2024, or $30,500 for those savers age 50 or older. For the previous tax year, the limits were $22,500 and $30,000, respectively.

Investment options: IRA versus 401(k)

IRAs and 401(k)s offer different investment options, since a 401(k) is limited to what your plan sponsor offers.

When you invest in an IRA, you can choose from a wide range of investments, including stocks, bonds, exchange-traded funds (ETFs), mutual funds and more.

A 401(k) typically comes with fewer options. Most plans are structured with a qualified default investment option (QDIA), which is usually a target-date fund. If you don’t choose an investment when you begin to contribute, your money will likely automatically be put into one of these funds.

“If you want to create a more robust allocation, I always recommend choosing the investments with the lowest expense ratios so think of index funds and avoid the managed funds,” Jariwala said. “The higher fees make it difficult for those funds to outperform the markets on a long-term time horizon.”

Early withdrawal penalties

Because the money you’re putting into these savings accounts is specifically for retirement, you’ll get dinged for withdrawing your money early — and those penalties can add up.

If you withdraw money from a retirement plan before age 59 1/2, the amount you take out is subject to taxation as gross income in addition to incurring a 10% penalty.

There are exceptions. Some 401(k) plans allow you to take hardship distributions without paying the 10% penalty to pay for qualified expenses like medical needs. The IRS also allows investors to make certain early withdrawals from IRAs without the 10% penalty, like for first-time homebuyers.

You can find the full list of early withdrawals that are exempt from taxes on the IRS website or by contacting your 401(k) plan sponsor.

Required minimum distributions

Once you reach age 73, you’re required to make required minimum distributions (RMDs) from traditional IRAs and employer-sponsored retirement plans. Since investors delay paying taxes on the money that’s put into these accounts, RMDs are how the government ensures you pay Uncle Sam.

Roth IRAs don’t have RMDs, since you fund them with after-tax dollars.

Your RMD is typically calculated by dividing the balance of the account as of the end of the prior year by a life expectancy factor from the IRS. However, many financial institutions that offer these retirement accounts will do the calculation for you and let you know when your RMD is due.

The year you turn 73, your RMD is due by April 1 of the following year. For all subsequent years, the RMD is due by December 31.

RMD penalties

Not taking your RMDs can cost you. As of 2024, if you don’t withdraw your RMD by the deadline, the amount not withdrawn is subject to a 25% excise tax. That rate can possibly be lowered to 10% if you correct the mistake within two years.

If you made an honest mistake and are trying to fix it, you might also be able to get the penalty waived by filling out Form 5329 and attaching a letter of explanation.

How IRAs and 401(k)s are taxed

Both IRAs and 401(k)s offer big tax benefits. But it’s important to understand exactly how they’ll impact your tax bill — now and in the future — before you invest.

Keep in mind that the following covers tax treatment for traditional IRAs and traditional 401(k)s. Roth IRAs and Roth 401(k)s have different tax treatments, as they are funded with after-tax dollars, which means you don’t pay taxes when you withdraw that money in retirement.

IRA contribution deductions

You may be able to deduct contributions that you make to a traditional IRA when you do your taxes.

The deduction is limited if you or your spouse (if you’re filing taxes jointly) have an employer-sponsored retirement plan, too, and if your income exceeds a certain amount. But if you don’t have a retirement account plan at work, your deduction for a traditional IRA may be allowed in full.

You can check with the IRS on those income limits here if you are covered by a retirement plan at work and here if you’re not covered by a retirement plan at work.

401(k) deductions

While you can’t deduct contributions to 401(k)s on your tax return, your employer takes your contributions into account and lowers your taxable income accordingly.

Remember that we’re talking about traditional 401(k)s. Contributions to your Roth 401(k) won’t lower your taxable income since those contributions are made with after-tax dollars, just like a Roth IRA.

How IRA and 401(k) distributions are taxed

Withdrawals from your traditional IRA or 401(k) after the age of 59 1/2 are treated as ordinary income. 2023’s marginal income tax rates are listed on the IRS website.

How to choose between an IRA and a 401(k)

There are many differences between IRAs and 401(k)s, and determining which retirement plan makes most sense for you will come down to your specific financial situation and goals. But you don’t necessarily have to choose between the two.

If your employer offers a 401(k), you likely want to take advantage of that — especially if the company offers an employer match. If your employer doesn’t offer a retirement plan, an IRA is a good way to ensure that you’re still saving money on your own.

In order words, sometimes the decision is made for you based on the resources available to you. However, you may also want to consider investing in an IRA on top of a 401(k).

Once you contribute up to the match, consider maxing out your Roth IRA for the year, Jariwala said. Then — if you max out the Roth IRA and still have funds available — go back and allocate more to your 401(k) plan, she added.

IRA versus 401(k): Pros and cons of each

While retirement savings accounts come with impressive benefits, there are also downsides to consider.

Pros of IRAs

• Tax-free growth: Contributions to traditional IRAs are not taxed, which means you don’t have to pay taxes on capital gains and dividends until you’re ready to pull your money out in retirement. Roth IRAs also come with a tax benefit in that you don’t have to pay taxes on your withdrawals because you contribute after-tax dollars. If you expect your income (and tax rate) to be lower in retirement, this can be a huge advantage.
• Tax-deductible contributions: The money you contribute to a traditional IRA can lower your taxable income, thus reducing your tax bill.
• Accessibility: Anyone with earned income is allowed to open and contribute to an IRA, and doing so online is relatively easy. There’s also no age limit for opening an IRA.
• Flexibility: Because you own your IRA — not an employer — you can invest in a wide range of options, similar to if you were to open a regular taxable brokerage account.

Cons of IRAs

• Contribution limits: While financial planners are big advocates of saving for retirement, you can be penalized for saving too much in one of these accounts if you exceed the contribution limits set by the IRS.
• Early withdrawal penalties: Because the money saved in these accounts is meant for retirement, taking it out before you hit age 59 1/2 can be subject to a 10% penalty in addition to being taxed as ordinary income.

Pros of 401(k)s

• Tax-free growth: Like IRAs, money that you contribute to a traditional 401(k) — not a Roth 401(k) — is tax-free, so you don’t have to pay taxes on capital gains and dividends until you withdraw.
• Tax-deductible contributions: The money you contribute to a traditional 401(k) lowers your taxable income. Plus, you don’t need to report deductions on your tax returns.
• Easy contributions: Making contributions to a 401(k) is simple since you’ll typically set them up to automatically come out of your paycheck. Your human resources department will often automatically enroll you or send you all the necessary paperwork.
• Employer match: If your employer offers a 401(k), they probably offer an employee match, too. That workplace perk is essentially free money.

Cons of 401(k)s

• Contribution limits: If you contribute more to a 401(k) than the IRS allows annually, you’ll face penalties.
• Early withdrawal penalties: Like IRA investors, 401(k) owners can face a 10% penalty for withdrawing from their account before age 59 1/2 in addition to having to pay taxes on that withdrawal.
• Fewer investment options: Because a plan sponsor runs your 401(k), you may not have as many options as you would if you invested in an IRA.
• Potential fees: Some 401(k)s come with fees such as management costs. Often, participants aren’t even aware of these fees unless they take a close look at the annual fee disclosures from the plan sponsors.

Frequently asked questions (FAQs)

What are the tax considerations for IRAs and 401(k)s?

Contributions to traditional IRAs and 401(k)s can lower your taxable income. You also don’t pay taxes on the money you put into these accounts until you take distributions in retirement.

Those distributions are eventually taxed at ordinary income tax rates. Note that this is different from Roth IRAs and Roth 401(k)s, which are funded with after-tax money so that distributions are tax-free.

When can you withdraw money from an IRA and a 401(k)?

The money in your retirement savings accounts is yours, which means you can technically withdraw it at any time. However, you need to wait until you hit age 59 1/2 to ensure you won’t face any penalties.

Can you have both an IRA and a 401(k)?

Yes. In fact, many financial advisors say that it’s ideal to contribute to both an IRA and 401(k). Just ensure that you also have an emergency fund, and aren’t foregoing investing for other life goals that may come up sooner than retirement.

What are the penalties for early withdrawal in IRAs and 401(k)s?

If you make withdrawals from an IRA or 401(k) before you turn 59 1/2 years old, the amount you take out is subject to taxation as gross income in addition to incurring a 10% penalty.

There are some exceptions, which are outlined via your 401(k) plan sponsor or the IRS.