In the showdown of IRA vs. 401(k), which wins? That depends on your retirement savings needs. Just because you have access to a 401(k) through work doesn’t mean you should necessarily max it out. Consider what a 401(k) and an IRA can do for you before investing your hard-earned dollars in one or the other. Let us walk you through the important differences between 401(k)s and IRAs. It always makes sense to consult with a financial advisor as you work on a retirement plan.
IRAs vs. 401(k)s Defined
Before we delve into the differences, let’s first establish what an IRA and a 401(k) are. A traditional IRA, or individual retirement account, is a retirement savings account available to anyone at any age, as it’s not offered through an employer.
A 401(k) is a qualified employer-sponsored retirement plan that’s available only if your employer chooses to offer it. Both 401(k)s and traditional IRAs are solid options for tax-advantaged retirement savings, as you don’t pay taxes on your contributions until after you withdraw your money during retirement.
Differences of IRAs and 401(k)s
If you’re trying to decide between retirement accounts then it’s important to understand the major differences. There are three main things that you should understand before opening either account.
Difference 1: Contribution Limits
401(k)s have higher contribution limits than IRAs. In 2024, you can contribute up to $7,000 a year to an IRA. The maximum contribution limit for a 401(k), on the other hand, is $23,000. The catch-up contributions mean folks 50 and over can put a total of $8,000 for IRAs and $30,500 for 401(k)s.
It’s easy to see that the 401(k) boasts significantly higher contribution limits. If you’ve got a high salary – or even if you don’t but you’re serious about saving a lot for retirement – the 401(k) lets you save more.
Difference 2: How You Contribute
Anyone who meets the investment minimum (usually $1,000 but sometimes less) can easily open an IRA with a brokerage firm online. 401(k)s, though, are offered through private-sector employers. You can’t hop on the internet and open a 401(k) for yourself. You must work for a company that offers you access to a 401(k).
Whereas you contribute to an IRA by sending money to the brokerage firm that holds your account, your 401(k) contributions are generally deducted from your paycheck at work before you even see the money. That can make it easier to save. With a 401(k) you’re not tempted to spend the money because it never hits your paycheck. If you’re having trouble committing to a savings plan a 401(k) might be the hack that puts you on the right track.
Difference 3: Portability
If you leave the company that sponsors your 401(k) you can’t keep contributing to it. You can either leave it where it is, roll it over to an IRA or roll it over to a 401(k) at your new company. IRAs, on the other hand, aren’t attached to your employer. You don’t have to jump through any hoops if you change jobs. This makes an IRA a lot more flexible and it can be less of a hassle.
IRA vs. 401(k): Which Is Better for You?
Still not sure which one to pick in the battle of IRA vs. 401(k)? One major thing to consider when deciding between a 401(k) and an IRA is employer matching. Some companies offer to match employees’ 401(k) contributions up to a certain amount. For example, an employer may match your contributions up to 6% of your salary. That’s money you should take. Failing to contribute enough to your 401(k) to get the maximum employer match is leaving money on the table. Dude, it’s free money!
After you’ve contributed enough to get the biggest employer match possible, you can either continue contributing to your 401(k) or contribute to an IRA. If the 401(k) options available to you have relatively high fees you may want to stop contributing once you’ve earned the full match and instead contribute to a low-fee IRA.
The Benefits of Having Both an IRA and a 401(k)
There’s no rule against saving for retirement in both a 401(k) and a traditional IRA. Depending on your income, though, you might not be able to deduct your contributions to the IRA if you’re also saving in a 401(k). That’s because the IRS imposes income limits to restrict who can make tax-deductible contributions to both a 401(k) and an IRA.
For tax year 2023, if you’re filing as an individual and your AGI is $153,000 or more you can’t deduct your IRA contributions. Married filing jointly? The income limit is $228,000. For 2024, these limits change to $161,000 and $240,000, respectively.
An Alternative: What About a Roth IRA?
A Roth IRA may make more sense than a traditional IRA as a complement to a 401(k) account. Why? Roth IRAs have a different set of tax advantages. Both IRAs and 401(k)s are tax-deferred accounts. Start taking distributions from them in retirement and you’ll owe income taxes on the money you withdraw. So, if you have both a traditional IRA and a 401(k) you’re doubling up on the same tax strategy. If your taxes are high in retirement you’ll just have to deal.
Plus, both 401(k)s and traditional IRAs come with Required Minimum Distributions (RMDs). Once you hit age 73 (75 in 2033) you’ll have to start taking distributions from the account. If you have other income sources, taking those RMDs can mean you’re forced to withdraw more money than you need and you might get bumped to a higher tax bracket in the process. Bummer.
Roth IRAs, unlike traditional IRAs, are funded with after-tax dollars. As a result, distributions you take from a Roth IRA in retirement are tax-free. Sweet! Having both a 401(k) and a Roth IRA gives you more flexibility to manage your income-to-tax ratio in retirement.
Of course, there are income limits that govern who is eligible to contribute to a Roth IRA, but contributing to a non-deductible IRA and converting it to a Roth can help you get around those limits. Remember that the $7,000 annual limit for contributing to an IRA applies to all of your IRAs, so if you have a traditional IRA and a Roth IRA you can’t contribute $7,000 to each one.
Bottom Line
Having enough money to save for retirement puts you in a privileged position relative to many Americans. The important thing to keep in mind is that a) you should always take advantage of an employer match and b) you want a retirement plan with low fees. The more accounts you hold, the more you’ll pay in fees and the more work you’ll have to put into making sure your assets are balanced across all those accounts.
Tips for Saving for Retirement
- Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Start saving for retirement early. No matter which retirement savings account you settle on, it’s always better to start saving sooner than later. The sooner you invest your money, the more time you have to reap the benefits of compound interest. This can have a big impact on your retirement savings.
Photo credit: © iStock/jygallery, © iStock/vm, © iStock/malerapaso