Saving for retirement can be a bit complicated due to the many retirement plans to choose from with different rules. There are a lot of retirement plans available and choosing one of them can be a major challenge. Common retirement plans include 401(k) plans and IRAs. Knowing how IRAs and 401(k) plans differ can help you make the right financial decisions and maximize your retirement savings. This article will compare the pre-tax 401(K) vs. traditional IRA and help you decide which retirement plan is best for you.
What is a Traditional IRA?
A traditional IRA is a retirement account that allows you to make before-tax contributions toward retirement savings. With a traditional IRA, you grow your account on a tax-deferred basis and pay tax when taking distributions during retirement.
Traditional IRA key takeaways:
- It is easy to open and set up a traditional IRA
- You manage your IRA and make investments yourself. Your broker can also manage your account for a small fee.
- Fees for IRAs are lower compared to 401(k) plans
- You can open a traditional IRA from any bank, credit union, or brokerage firm and similar financial institutions
- A traditional IRA comes with a wide range of investment options such as mutual funds, index funds, ETFs, bonds, individual stocks, etc.
- The contribution limits to a traditional IRA are much lower compared to 401(k) limits. For 2024, you can contribute up to $7,000 in your traditional IRA or $8,000 if you are 50 or older. For your 401(k), you can contribute up to $23,000 or $30,500 if you are 50 or older.
- Contributions to a traditional IRA can be tax-deductible
- Traditional IRA come with required minimum distributions(RMD) when you turn 73
Like any other retirement plan, the Traditional IRA offers tax benefits to account holders. According to the Internal Revenue Service(IRS), contributions to your Traditional IRA can be fully or partially deductible depending on your income, filing status, and other benefits you have from your employer.
A Traditional IRA is good for you if you don’t have 401(K) benefits from your employers or if you want more flexibility in investment options while reducing account management fees.
What is a 401(K) plan?
A 401(K) plan is another retirement plan that is popular due to tax saving benefits. The money you contribute to your 401(K) comes from your before-tax wages through payroll deduction. For this reason, you must pay income tax on your distributions during retirement.
Pre-tax 401(k) key takeaways:
- 401(k) contributions come from your before-tax wages through payroll deductions
- All contributions to pre-tax 401(k) are tax-deductible
- You grow the account on a tax-deferred basis
- 401(k) plans are sponsored by your employer and managed by a third-party company
- Without employer sponsorship, you cannot open a 401(k) plan on your own
- Most 401(k) plans come with an employer match
- You pay an income tax on 401(k) withdrawals during retirement
- 401(k) fees are higher than traditional IRA fees especially if you have actively managed funds in your portfolio
- You are limited to investments(usually mutual funds) inside your plans
- 401(k) plans allow higher contribution limits compared to a traditional IRA. For 2024, you can contribute up to $7,000 in your traditional IRA or $8,000 if you are 50 or older. For your 401(k), you can contribute up to $23,000 or $30,500 if you are 50 or older.
- The pre-tax 401(K) comes with the required minimum distribution(RMDs) when you turn 73.
Related: How much should you contribute to your 401(K) account
401(K) vs. traditional IRA
| Features | 401(K) plan | Traditional IRA |
| The contribution limit in 2024 | $23,000 or $30,500 if you are 50 or older | $7,000 or $8,000 if you are 50 or older |
| Required minimum distribution(RMD) | There is an RMD when you turn 73. Failure to meet your RMD requirements could result in a 50% tax penalty on the amount you did not take out on time. | There is an RMD at 73. Failure to meet your RMD requirements could result in a 50% tax penalty on the amount you did not take out on time |
| Early withdrawal penalty | You pay a 10% penalty and tax on withdrawals you take out when you are under 59½. This penalty may be waived if you meet the IRS exceptions. | Withdrawing money from your IRA when you are under 59½ will result in a 10% penalty plus taxes. This penalty can be waived if you meet IRS exceptions. |
| Tax on withdrawals | You pay an income tax on your distributions | You will pay income tax on the deductible contributions you made toward the account. |
| Tax deductibility | Contributions are tax-deductible | Your contribution can be fully or partially deductible depending on other benefits you have from work, filing status, and income. |
| Who is eligible? | If your employer has 401(K) and you are approved to contribute. Some employees could be excluded from contributing if they are not 21, have not worked for 1 year, etc. However, you cannot be excluded just because you are older. | Anyone with taxable income. Keep in mind that your contributions should not be above the acceptable limit and all your contributions may not be deductible. |
| Employer matching | Your employer may match your contributions up to a certain percentage | Does not have a match since it is not sponsored by employers |
| Fees | Comes with higher plan management fees | You can shop around for lower fees |
| Investing flexibility | You are limited to investments you have inside your plan | Comes with a lot of investment options such as ETFs, Mutual Funds, or individual stocks |
Pre-tax 401(K) vs. traditional IRA: Which one is better?
By default, the 401(K) plan is much better than the traditional IRA. Your 401(K) comes with a much higher contribution limit of $23,000 or $30,500 if you are 50 or older. In addition, you can get free money from your employer through contribution matching. On top of these benefits, the pre-tax 401(K) plan will lower your taxable income at a bigger rate compared to a traditional IRA due to a higher contribution.
The drawback of 401(K) is that your account comes with higher fees and limited investment options.
The traditional IRA, on the other hand, comes with a lower contribution limit of $7,000 or $8,000 for people who are 50 or older. Furthermore, all your contributions to a traditional IRA may not be deductible.
Compared to 401(k) plans, you can easily open an IRA from financial institutions such as banks and brokerage firms. This flexibility gives you a chance to manage your account. Since you can shop around for lower rates, a traditional IRA is better on fees and investment options compared to a 401(K) plan.
With a traditional IRA, you have a wider range of investment options to choose from. You can invest in Stocks, Mutual Funds, Index Funds, Exchange Traded Funds, etc. You will not have all these options with a 401(K).
Related: How much should you contribute to your 401(K) account
What are the similarities between 401(k) and a traditional IRA?
The 401(k) and traditional IRA are retirement plans where contributions are fully or partially tax-deductible and you grow your accounts on a tax-deferred basis. Both accounts come with income tax on your distributions and they require RMDs when you turn 73. Additionally, you will pay a 10% penalty if you withdraw money from any of these two accounts before you turn 59½. From an investment perspective, both plans allow you to choose investments within the accounts.
401(k) vs. traditional IRA: What is the difference?
The 401(k) plan is sponsored by your employer and contributions come from your before-tax wages through payroll deduction. For the Roth IRA, on the other hand, you open the IRA from a bank, credit union, or other financial institution such as a brokerage firm. You then make contributions to your IRA from your bank account and get tax deductions when you are filing your taxes.
The 401(k) plan might also come with an employer match while the traditional IRA does not have matching as it is not sponsored by employers. In addition, 401(k) plans come with higher contribution limits compared to traditional IRA limits.
How to choose between a 401(K) and a traditional IRA?
When it comes to tax savings, both 401(K) plans and traditional IRAs give you tax benefits. The only difference is that 401(K) lowers your taxable income more than a traditional IRA due to a higher contribution limit. During retirement, you pay tax on your distributions on both accounts.
For this reason, if you want to lower your taxes, contribute more money to your 401(K) or up to your employer’s matching percentage. With this strategy, you will be reducing your tax and getting all free money from your employer. After reaching your employer matching percentage, start funding your traditional IRA.
The money in your traditional IRA will not give you special tax benefits. However, you will not tie all your savings in a 401(K) where fees are much higher with limited investment options.
If you still have more money to contribute after maxing on your traditional IRA, put that money into your 401(K).
Related post: How many IRAs can you have in 2024?
The best retirement savings strategy
If you have a 401(k) with your employer, open a Roth IRA instead of a traditional IRA. The Roth IRA will not give you direct tax benefits, but you will grow your account tax-free and pay no income tax on your withdrawals during retirement. Additionally, Roth IRAs do not come with RMDs and you can pass the account to your heirs tax-free.
The point here is that the 401(k) plan will lower your current tax liabilities while the Roth IRA will lower your retirement tax liabilities. That is why having a combination of a 401(k) plan and a Roth IRA is the best combination of retirement plans you can have.
Related: Can you have both 401(k) and IRA at the same time?
401(K) contribution limits in 2024
In 2024, the maximum contribution to 401(K) is $23,000. If you are 50 or older, you can contribute an extra $7,500 catch contribution.
One of the benefits of 401(K) plans is that your employer can match your contributions up to a certain percentage which is free money to help you grow your net worth fast.
Traditional IRA contribution limits in 2024
In 2024, you can contribute $7,000 or $8,000 if you are 50 or older to your traditional IRA, according to the Internal Revenue Service(IRS). Keep in mind that all your contributions might not be tax-deductible due to your income, filing status, and other benefits you have from your employer such as a 401(k) plan. Additionally, if your taxable income is less than the maximum contribution limits to an IRA, you must contribute up to your income for that year.
For example, if your income for 2023 is $5,000, the maximum contribution you can make for the same year is $5,000 even if the IRS allows a contribution limit of $6,500 for 2023. In other words, the contribution to your traditional IRA will be the limit we stated above or equal to your taxable income, whichever is lower.
Early withdrawal penalty on 401(k) vs. traditional IRA
The money you contribute to your retirement accounts must stay there until you have reached retirement age. The IRS requires that you reach 59½ before you can withdraw money from both your 401(K) and traditional IRA accounts.
Failure to meet this requirement leads to paying a penalty and tax on the money you withdraw. According to the IRS, early withdrawal from your 401(K) or traditional IRA account will result in a 10% penalty and tax on the money you withdraw. This 10% penalty may be waived if you meet the IRS exceptions.
Contribution age limit on traditional IRA
Before 2020, people who were 70.5 years and older were not allowed to make contributions to their Roth IRAs or traditional IRAs. This limitation has been lifted in 2020. In other words, there is no age limit on making contributions to IRA accounts.
