IRA vs. Roth IRA vs. 401k: Key Differences

Many employers offer 401(k)s and match your contributions. Other workplaces, however, might not offer this retirement plan. And, if you are an independent contractor, you may also be looking for another retirement plan alternative. In these cases, individual retirement accounts (IRAs) are versatile, accessible investment accounts that offer different tax benefits. Here’s a comparison of the advantages and disadvantages between IRAs, Roth IRAs and 401(k)s for your retirement.

Do you have questions about saving for retirement? Speak with a financial advisor about your plans today.

How Traditional and Roth IRAs Work

An individual retirement account (IRA) is a financial tool that allows you to save for retirement. By depositing money into an IRA, you invest in stocks and bonds that provide returns. Unfortunately, it’s also possible to lose money in the account if the investment portfolio underperforms.

Anyone can open an IRA, but the government restricts how much you can deposit and when you can withdraw funds. For 2024, you can invest a maximum of $7,000 per year in your IRA ($8,000 if you are age 50 or older). This is up from $6,500 in 2023 ($7,500 for those age 50 and older). While you can access your funds at any time, you’ll pay a 10% penalty for withdrawing money before age 59.5. This rule helps investors orient their IRA investment strategy toward retirement.

There are two types of IRAs: traditional and Roth. Traditional IRAs allow you to contribute pre-tax dollars to the account, lowering your taxable income. The government doesn’t tax your deposits but will tax the distributions you receive during retirement. On the other hand, Roth IRAs use money that the government has already taxed. As a result, your distributions during retirement are tax-free.

How 401(k) Plans Work

A 401(k) is an employer-sponsored retirement account. The only way to access one is if your employer offers it. A 401(k) allows you to deposit a portion of your paycheck before taxes to an investment account. By law, you can contribute up to $23,000 annually to your 401(k). Like an IRA, a 401(k) can lose money on its investments.

Typically, employers offering workers the 401(k) benefit also have matching contributions. In this situation, your employer matches a specific amount of your contributions. For example, a 5% matching contribution means if you deposit 5% of your total annual pay into your 401(k), your employer will also deposit that amount. As a result, matching contributions double your investment amount up to a specific percentage of your paycheck.

IRA vs. Roth IRA vs. 401(k): Contribution Limits

Both traditional and Roth IRAs have the same contribution limits. As we already explained, you can contribute up to $7,000 annually in 2024. If you’re age 50 or older, you can invest up to $8,000, as the IRS allows those in that age bracket to invest an additional $1,000 a year.

On the other hand, 401(k)s have a more generous limit of $23,000 annually in 2024, allowing you to invest more for retirement. Employees age 50 and older can deposit $30,500 annually, as again the IRS lets these investors contribute an extra $7,500 a year.

IRA vs. Roth IRA vs. 401k: Distributions

The federal government mandates that if you have a traditional IRA, you must take required minimum distributions (RMDs) by age 73 (up from 72 as of 2023). Of course, you can take distributions without penalty after age 59.5. Conversely, because the government has already taxed the money inside, Roth IRA funds have no mandatory distribution requirements.

401(k) distributions have distinct rules. You can begin withdrawing from your 401(k) when one of the following occurs:

You retire or change employers.
You pass away or become disabled.
You reach age 59.5.
You qualify for early withdrawals because of hardship.
Your employer terminates the 401(k) plan.

You can decide not to withdraw money from your 401(k) for a while in retirement. But, like IRAs, the government imposes a required minimum distribution upon reaching age 73 (unless you’re still working for the employer providing the plan).

IRA vs. Roth IRA vs. 401k: Employer Match

Traditional and Roth IRAs don’t have employer sponsorship, so there is no employer match. On the other hand, almost all employers offering a 401(k) also offer matching contributions. Roth 401(k)s are not eligible for matching contributions; only traditional 401(k)s are. An employer might match 1% or higher of your annual earnings contributed to the plan.

For example, let’s say your employer matches 5% of your paycheck contributions. Your salary is $50,000 and you contribute 10% ($5,000) of your income to your 401(k). Your employer matches the first 5%, or $2,500, of your paycheck contributions. At the end of the year, your total amount invested is $7,500.

IRA vs. Roth IRA vs. 401k: Investment Options

IRAs of both types allow you to invest in individual stocks, stock indexes, mutual funds, bonds and other assets. In other words, your options are virtually limitless with an IRA, including using a robo-advisor to create an investment portfolio. As a result, you can fine-tune your IRA to reflect your time horizon and risk tolerance. You can also invest in funds with low fees to minimize costs.

On the flip side, 401(k)s present employees with limited options. 401(k) plans usually have several portfolios available fitting different preferences, such as balanced, aggressive, or target-date funds which prioritize less risk the closer you get to retirement.

IRA vs. Roth IRA vs. 401k: Income Limits

Because Roth IRAs aren’t taxed upon withdrawal, the government restricts who can have one based on income. For 2024, those filing single or as a head of household with a modified adjusted gross income (MAGI) of $161,000 or less ($153,000 or less in 2023) can contribute to a Roth IRA. If you’re married and file jointly, you can contribute if your MAGI is $240,000 or less ($228,000 or less in 2023). Income levels above these benchmarks mean the government allows only minimal contributions to a Roth IRA.

There are also income limits for each filing status whereby if you surpass them, but still remain under the ultimate caps above, you can still contribute, but to a lesser degree. These go as follows:

Single/Head of household: contributions limited starting at $146,000
Married filing jointly: contributions limited starting at $230,000

401(k) plans have no such limits – workers of all income levels can contribute up to the maximum.

IRA vs. Roth IRA vs. 401k: Withdrawal Rules

Taking distributions from an IRA or 401(k) before age 59.5 will incur a 10% penalty fee on the withdrawal plus federal and state income taxes. Therefore, it’s ideal to withdraw funds in your IRA or 401(k) solely in retirement and deal with financial emergencies with money from other sources.

One of the few exceptions to this rule is using IRA money to pay for medical expenses that surpass 10% of your adjusted gross income – but it’s a good idea to use an emergency fund or savings account if possible.

Who Should Use an IRA, Roth IRA or 401(k)?

Since traditional IRAs use pre-tax dollars, it’s best to use one if you anticipate your taxable income during retirement to be lower than your income during your career. On the other hand, if you want to get taxes out of the way before retirement, a Roth IRA is better. Plus, you won’t have RMDs in retirement with a Roth, meaning you can start withdrawing at any point you choose after age 59.5.

Overall, IRAs give you ultimate flexibility with investments and pre- and post-tax contribution options. In addition, an IRA can be a good second investment vehicle if you have money left over after matching 401(k) contributions to invest.

401(k)s function best when supplemented with an employer match. This scenario gives you free money towards your investments, and you’ll likely have access to a balanced portfolio with reasonable fees. Without a match, you’re locked into a handful of funds that might not fit your preferred investment approach. However, a 401(k) is an excellent place for excess investing money if you max out your IRA contributions, even if you don’t get matching contributions.

Bottom Line

Traditional and Roth IRAs allow you to invest for retirement using stocks, bonds, mutual funds, and other assets while giving you the option to have your investment dollars taxed now or later. Their main drawback is the low annual contribution limit of $7,000 for 2024, meaning that you may have to look for a second investment vehicle if you have an IRA.

401(k)s solely come from employers, meaning your workplace has to provide one for you to access it. While Roth 401(k)s are becoming more widespread, allowing you to invest taxed dollars into a 401(k), matching contributions are only applicable to traditional 401(k)s. Matching contributions and a high annual contribution limit of $23,000 are the primary benefits of a 401(k). Therefore, investing in yours is a good idea to take advantage of matching contributions.

Tips for IRAs and 401(k)s

Having a plan for retirement entails more than contributing to an investment account. Your lifestyle in retirement, healthcare costs, and more are vital to preparing for retirement. A financial advisor can help you create a financial plan 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.
While 401(k)s have more inherent structure, you can modify your allocations in most plans to a certain degree. If you’re confused after reviewing your 401(k) options, you might want to speak to a financial advisor about your 401(k).