Retirement planning is a crucial step in securing a comfortable and worry-free life after work. But with so many options available, it can be overwhelming to know which retirement plan is best for you. Popular retirement savings accounts among millions of people are IRAs and 401(k) plans. The benefits you get from an IRA vs. 401(k) differ, and therefore, the plan you choose depends on your financial situation.
IRAs typically come with more flexibility in investment options and can help you lower your tax liability during retirement. On the other hand, 401(k)s allow higher yearly contributions which lowers your taxable income but you pay income tax on your withdrawals during retirement. Some employers offer matching contributions which is free money that boosts your savings.
While each IRA and 401(k) has its pros and cons, the best way to save for retirement is to use a combination of an IRA and 401(k) plan. This allows you to reap the full benefits of each account which helps you reach your financial goals faster.
If you are trying to figure out which retirement account is best for you, this article will explain how an IRA differs from 401(k) and what you should expect from opening each account.
Understanding IRA and 401(k) Plans
Before we start comparing IRA vs. 401(k), let’s first examine what these plans are in the first place.
What is an IRA?
An IRA stands for an individual retirement account and you can open it from your local bank, credit union, brokerage firms, and similar institutions. IRAs give you tax advantages for your retirement savings. There are two types of IRA which are a Roth IRA and a traditional IRA.
The main difference between both IRAs is when tax benefits are realized. A traditional IRA gives you upfront tax benefits where your contributions may be tax-deductible depending on your modified adjusted gross income(MAGI) and filing status. The Roth IRA, on the other hand, does not give you upfront tax benefits since contributions come from your after-tax wages but you grow your account tax-free, and qualified distributions are not taxed.
Related post: How to open a Roth IRA: Create a Roth IRA in 6 steps
What is a 401(k) plan?
A 401(k) is an employer-sponsored plan that allows you to save for retirement in exchange for tax incentives. Unlike an IRA where you can easily open an account by yourself from a bank or a brokerage firm, you must go through an employer to open a 401(k) plan. There are two types of 401(k) plans which are pre-tax 401(k) and Roth 401(k). The main difference between both 401(k) plans is that contributions to your pre-tax 401(k) come from your before-tax wages whereas contributions to your Roth 401(k) come from your after-tax money. All your contributions are made through payroll deductions.
Just like a Roth IRA, your Roth 401(k) grows tax-free, and qualified distributions will be tax-free. If your employer matched your Roth 401(k), however, the matching percentage will be tax-deductible, and applicable tax must be paid when taking distributions.
On the other hand, pre-tax 401(k) gives you direct tax benefits as your contributions are tax-deductible. This also means that you will grow your retirement savings on a tax-deferred basis and pay income tax on your distributions during retirement.
401(k) vs. IRA: Should you choose an IRA or a 401(k)?
Open an IRA if you want more control of your investment choices and want to pay less tax during retirement. With a Roth IRA, your contributions will come from after-tax wages. In return for paying tax now, you will grow your account tax-free, and qualified distributions will be tax-free. Depending on your MAGI and tax-filing status, contributions to your traditional IRA might be tax deductible and you will grow your account on a tax-deferred basis. Unlike Roth IRAs that offer tax-free distributions, withdrawals from traditional IRAs will be subjected to income tax during retirement.
Open a 401(k) if you want to pay less tax now and don’t mind paying more tax during retirement. This is because contributions to your pre-tax 401(k) are tax-deductible and you grow your retirement savings on a tax-deferred basis. The downside of this strategy is that you will pay an income tax on your distributions during retirement. This can easily put you in a higher tax bracket when you need money the most.
The Roth 401(k) on the other hand, behaves more like a a Roth IRA. The only difference is that any tax-deductible contributions to the account such as employer match are subjected to income tax during retirement. Additionally, Roth 401(k) allows higher contribution limits compared to a Roth IRA.
The best retirement saving strategy
While most people spend valuable time trying to choose between a 401(k) vs. an IRA, you probably don’t need to choose one over the other. This is because you can legally have a 401(k) and a traditional IRA at the same time and can contribute up to the maximum contribution allowed for each account which is the best retirement saving strategy.
For the 401(k), you can contribute up to $22,500 in 2023 and $23,000 in 2024. If you are 50 or older, the IRS allows you to contribute an extra catch-up contribution of $7,500 in 2023 and 2024.
For an IRA, you can contribute up to $6,500 in 2023 and $7,000 in 2024. If you are 50 or older, you get an extra catch-up contribution of $1,000.
If you are making enough income and want to boost your retirement savings, open both the 401(k) and IRA and contribute the maximum limit for each account.
On the other hand, if you want more flexibility with your funds, contribute up the employer matching percentage to your 401(k) and put the rest in your IRA.
IRA vs. 401(k): What is the difference?
Individual Retirement Accounts (IRAs) and 401(k) plans are popular retirement accounts but most people don’t know their differences. These two types of retirement savings plans differ from each other on four major factors including contribution limits, tax considerations, investment flexibility, and employer matching.
1. IRA vs. 401(k): Contribution limits
In terms of contribution limits, IRAs and 401(k) plans have different guidelines.
- IRA contribution limits. For IRAs, the maximum annual contribution limit is currently $6,500 in 2023 and $7,000 in 2024 for individuals under the age of 50, while those aged 50 and above can make an additional catch-up contribution of $1,000, according to the Motley Fool. These contribution limits are the same for both traditional IRAs and Roth IRAs.
- 401(k) contributon limits. 401(k) plans have higher contribution limits than IRAs, allowing individuals to contribute up to $22,500 in 2023 and $23,000 in 2024 for individuals who are under 50. According to the IRS, if you are 50 or older, you make an extra catch-up contribution of $6,500 in 2023 and $7,500 in 2024. These contribution limits are the same for both Roth 401(k) and pre-tax 401(k) plans.
2. IRA vs. 401(k): Tax benefits
When evaluating the tax advantages of IRA vs. 401(k), both plans offer potential tax advantages. Here is how IRAs and 401(k) differ in terms of tax savings.
- IRA tax benefits. Contributions made to traditional IRAs are often tax-deductible, meaning you can reduce your taxable income in the year you contribute. However, keep in mind that withdrawals from traditional IRAs in retirement are generally subject to income tax. Roth IRAs, on the other hand, do not offer upfront tax benefits but you get to withdraw your money tax-free.
- 401(k) tax benefits. 401(k) plans offer direct tax benefits annually, as contributions are typically made on a pre-tax basis, reducing your taxable income for the year. However, similar to traditional IRAs, withdrawals from 401(k) plans are subject to income tax. Some employers may also offer a Roth 401(k) option, enabling contributions with after-tax dollars, which can lead to tax-free withdrawals in retirement.
3. 401(k) vs. IRA: Investment options
The money you save into your retirement accounts must be invested in order to grow your net egg. While both 401(k) and traditional IRAs offer great investment options, they also come with different flexibility on investments you can pick which in turn affect your return on investments.
Here is how 401(k) plans differ from IRAs when it comes to investment options.
- IRA investment options. IRAs often provide a wider range of investment choices, including individual stocks, bonds, mutual funds, and exchange-traded funds (ETFs). You can also manage your own account which puts you in control of your investment options and how much you can earn.
- 401(k) investment options. 401(k) plans usually offer a limited selection of investment options managed by the plan provider. That is you can only invest in funds that are inside your plan which are pre-selected by the plan provider. This lack of flexibility limits your ROI but also keeps your account safer as these investments are designed to be safer.
4. 401(k) vs. IRA: Employer matching contributions
An important factor to consider when comparing IRA vs. 401(k) plans is the employer matching contributions. Employer matching can significantly impact your retirement savings. Keep in mind that not every employer offers retirement benefits and those who do are not required to match your contributions. Here is what you need to know about employer matching between 401(k) plans and IRAs.
- 401(k) employer matching contributions. Most employers that offer 401(k) plans also match their employer’s contributions up to a certain percentage. For example, your employer can match your contribution up to 6% of your gross income. This means that your employer will match your contribution up to 6% of your gross income. For example, if you are making $100,000 per year, your employer can match your contribution up to $6,000. Note that employer matching contributions may be subject to vesting requirements, meaning you may not have immediate access to the full amount.
- IRA matching contributions. IRAs do not have matching contributions as employers do not offer them.
Things to consider when investing in your IRA and 401(k)
Saving for retirement is one of the best ways to legally pay less tax and build wealth faster with less work. To take full advantage of your retirement savings, however, there are a few things you need to keep in mind.
Here are a few things you need to know when saving for retirement.
Retirement accounts come with early withdrawal penalties
One of the biggest drawbacks of retirement savings accounts is that they are subjected to early withdrawal restrictions. That is unless you have reached the proper retirement age designated by the IRS, accessing funds in your retirement plan may lead to paying an early withdrawal penalty.
Both IRA and 401(k) require that you reach 59 ½ before you can take distributions penalty-free. If you take money out of your account before reaching this retirement age set by the government, a 10% penalty is applied to your funds as an income tax. Note that this is not the same as your normal income tax. You will still need to pay your actual income tax on top of this 10% penalty.
Unlike the 401(k) plan, the penalty does not apply when you take your own contributions from your Roth IRA and you have held your account for at least 5 years. However, earnings from your account might be subjected to a 10% penalty and an income tax.
Contribution limits
For each retirement account you pick whether it is an IRA or 401(k), there is a contribution limit allowed by law. With an IRA, the maximum contribution limit is $6,500 in 2023 and $7,000 in 2024. If you are 50 or older, you get an extra $1,000 catch-up contribution.
If you have a 401(k) plan, you can contribute up to $22,500 in 2023 or $23,000 in 2024. Those who are 50 or older, get a catch-up contribution of $7,500.
Comparing an IRA vs. 401(k) plan, you can easily see that the 401(k) plan allows you to stash away more money which greatly lowers your taxable income. Assuming that you have a traditional IRA and a 401(K), your IRA will lower your taxable income up to $7,000 while the 401(k) will lower your income by $23,000.
If you are interested in lowering your taxable income above everything else, contributing the maximum allowed in your pre-tax 401(k) will be the best choice. If you still have more cash to contribute, then open a traditional IRA to further lower your taxable income.
Required minimum distributions(RMDs)
RMDs are minimum distributions you are required to take from your retirement account every year after turning 73. Accounts that require RMDs are pre-tax 401(k), 403(b), and similar retirement accounts, traditional IRA, SEP IRA, and SIMPLE IRA. If you are still working and have 401(k) plans by the time you turn 73, you can delay taking RMDs until your official retirement date, unless you own 5% or more in the business that sponsors your plan.
What makes a Roth IRA stand out is that RMDs are not required for a Roth IRA. After the owners of the Roth accounts pass away, however, beneficiaries of the account are required to take RMDs and the entire account must be withdrawn within 10 years. Starting in the year 2024, RMDs will no longer be required for all Roth accounts including Roth 401(k)s, according to the Internal Revenue Service (IRS).
RMDs are usually not your biggest worry when saving for retirement. Unless you are super rich, you will need to make withdrawals from your retirement accounts. For this reason, RMDs should not be a big concern. But if you think you will need to pass the account to your beneficiary without paying taxes, then, opening a Roth IRA is a great choice as it allows you to transfer your wealth to descendants tax-free and does not require RMDs.
Tax deduction
If you need to really compare IRA vs. 401(k) plan, focus on tax benefits and when those benefits are realized. When you make contributions to your 401(k) plan, the money comes directly from your pre-tax wages through payroll deduction. For your Pre-tax 401(k), contributions come from before-tax wages which makes them tax-deductible. On the contrary, any contributions you make to your Roth 401(k) come from your after-tax wages which makes them ineligible for tax deductibility.
For the IRA, on the other hand, contributions come from your own account such as a checking account or a savings account. If you are making contributions to your Roth IRA, these contributions will not be tax-deductible. However, you will grow your account tax-free and take tax-free distributions. For the traditional IRA, on the other hand, your contributions might be tax-deductible. It will all depend on your adjusted gross income income and filing status.
While all your contribution to a pre-tax 401(k) plan is tax-deductible, IRAs do not guarantee these benefits. Any contributions you make to your Roth IRA will not be tax-deductible which means that Roth IRA no not offer direct benefits. A Roth IRA will benefit you if you want to lower your tax liability during retirement. For the traditional IRA, however, your contributions might be tax-deductible. It will all depend on your modified adjusted gross income(MAGI).
Related: What are the traditional IRA income limits for 2022
Making a retirement savings decision
When deciding between an IRA and a 401(k) plan, weigh the advantages and disadvantages of each plan. One key factor to consider is the level of control you want to have over your investments. With an IRA, you have a wider range of investment options compared to a 401(k) plan, which often offers a limited selection of mutual funds. If you prefer a more hands-on approach and want the freedom to choose from a variety of investment choices, an IRA might be the better choice for you.
On the other hand, a 401(k) plan provides convenience and simplicity in managing your retirement savings. Contributions to a 401(k) plan are automatically deducted from your paycheck, making it easy to save consistently. Additionally, some employers may offer additional benefits like matching contributions, which can significantly boost your retirement savings. If your employer offers a 401(k) plan with attractive features, it might be worth considering to take advantage of these benefits. In case, you need more control of your finances and investment choices, at least contribute up to the matching contribution to avoid leaving free money on the table.
You should also consider tax implications when choosing between an IRA vs. 401(k). Contributions to a traditional IRA are generally tax-deductible, allowing you to reduce your taxable income for the year. You then grow your account on a tax-deferred basis and pay taxes on withdrawals during retirement. With a Roth IRA, contributions are made with after-tax dollars, but qualified withdrawals in retirement are tax-free. On the other hand, contributions to a traditional 401(k) plan are tax-deductible, while withdrawals during retirement are taxed as ordinary income. Conversely, Roth 401(k) contributions are made with after-tax dollars, but withdrawals in retirement are tax-free.
