IRA vs. 401(k): Which is Better for You?

IRA vs. 401(k) — what’s the difference, and which is better for you? IRAs and 401(k)s are two different retirement plans that allow individuals to invest and save for retirement. Saving in either is a great way to set money aside for retirement because they both have valuable tax benefits and offer potential investment gains.

The simplest way to differentiate these two retirement plans is to understand that a 401(k) is available to you through your employer, and an IRA is something you set up for yourself.

Both of these plans grow tax-free, which means there’s no tax on the interest and earning over the years, and that makes them a great way to set money aside for your golden years.

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IRA vs. 401(k): Which is Better for You?

	IRA	401(k)
What it is	Individual retirement account that you set up for yourself	Employer-sponsored retirement account
Contribution limit	$6,000 in 2021, $7,000 if age 50 or older	$19,500 in 2021, $26,00 if age 50 or older
How to get started	Open IRA through a bank or brokerage	Check with your employer’s HR department
What you can invest in	Wide variety of ETFs, mutual funds, individual stocks, and bonds	Your employer will likely limit you to a preselected list of investments

A Quick Glance at IRA vs. 401K

An IRA and 401(k) are both tax-advantaged retirement accounts, and you can contribute to both of them simultaneously. There are several differences, but the biggest difference between an IRA and 401(k) is that individuals open IRAs and employers offer 401(k)s.

Another key difference is that there are typically far more investment options for your IRA compared to a 401(k). You open an IRA through a bank or brokerage, and you can self-direct your investments, or use a robo-advisor.

Because a 401(k) is offered through your employer, they usually have set portfolios for you to invest through, and you make contributions from your paycheck. Your employer may offer a match of some kind, which is seen as a part of your employee compensation plan.

That’s the short answer to understanding the differences between an IRA and 401(k). Read on to learn about the differences between retirement account types, contribution limits, how to get started, and more.

What Is an IRA?

IRA stands for Individual Retirement Account, and it’s a kind of tax-deferred retirement savings account that you can establish for yourself. IRAs have specific contribution limits, and there are several different kinds of IRAs, including ones meant for self-employed people.

When you hear IRAs talked about, you often hear people mention Roth vs. traditional IRA. The difference between these is the tax advantage you choose, whether you receive a deduction on your contribution or take tax-free disbursements in retirement.

Traditional IRA

A traditional IRA is best for people who want a tax break the year they make contributions, that’s because contributions may be deductible, then lowering your tax income for the year. Once you retire, disbursements are taxed as ordinary income.

The contribution limit — the maximum amount you can contribute to your traditional IRA — is $6,000 in 2020 and 2021. People over 50 can make an additional catch-up contribution of $1,000. Contribution limits are the same for traditional and Roth IRAs.

Roth IRA

Roth IRAs are best for those who think they’ll be making more in retirement. The reason is that you make contributions to your Roth IRA with after-tax dollars, as in you’ve already paid taxes on that money, and the result is that you don’t pay taxes on qualified disbursements taken in retirement.

SEP IRA

SEP stands for Simplified Employee Pension, and it’s an employer-sponsored retirement plan commonly used by small business owners and self-employed people who want to save for retirement. Here are key takeaways with SEP IRA:

• SEP IRA contribution limits are much higher than standard IRAs — 25% of the employee’s compensation for the year as long as that does not exceed $58,000 for 2021. It goes up to $64,500 for employees 50 and older.
• Only employers make contributions to the account.
• SEP IRAs function like a traditional IRA.

Read more at SEP IRA vs. Simple SIMPLE IRA | What’s the Difference?

SIMPLE IRA

SIMPLE stands for Saving Incentive Match Plan for Employees. They’re available only for employers with no more than 100 employees, each earning more than $5,000 in the previous year. Here’s what you need to know about SIMPLE IRAs:

• SIMPLE IRAs encourage employees to contribute to their retirement.
• They are less complex for employers to set up compared to 401(k)s.
• The major drawback is that the business owner can’t save as much for their retirement as other retirement accounts.
• SIMPLE IRA contribution limits are $13,400 for 2020, $16,500 if you’re 50 or older. And employers are obligated to make contributions either as non-elective contributions or dollar-for-dollar matching contributions.

How to open an IRA

When it comes to opening an IRA vs. 401(k), IRAs are designed to be opened by individuals. You can open one at a bank or brokerage — most robo-advisors and micro-investing apps offer them now. Look for a brokerage that offers low trading and management fees.

IRAs opened at bank typically take the form of an IRA CD, or certificates of deposit, which usually have lower yields than investments.

If you open your IRA at a brokerage, you’ll have far more choice for what your funds are invested in, and ETFs and mutual funds are some of the best options for new retirement investors. You can self-direct your investments, or let a robo-advisor recommend and invest in a portfolio for you.

M$M tip: I highly recommend using <em>Personal Capital</em> to keep track of your investments, net worth, and find ways to save on investment fees. Personal Capital is a free tool, and you can connect all of your financial accounts and keep track of them in one place.

What Is a 401K?

The key feature of a 401(k) is that it’s an employer-sponsored retirement plan. Another major difference between an IRA and 401(k) is that contributions made to your 401(k) come through elective salary deferrals, meaning a percentage of your salary is withheld and goes into your 401(k).

401(k) contributions

Contributions made to a 401(k) are made with pretax dollars, meaning contributions come off the top of your paycheck before taxes are taken out. The money you contribute to your 401(k) can then lower your tax liability. For example, if you made $60,000 a year and contributed $5,000 to your 401(k), your taxable income goes down to $55,000.

Another significant difference between an IRA vs. 401(k) is that contribution limits are much higher. The contribution limit for 2021 is $19,500. If you’re 50 or older, you can make an additional catch up contribution of $6,500, for a total of $26,000.

Some companies offer employer matching 401(k) contributions — they’re different company to company, but the average match is around 4% of your pay. Again, plans vary, but the match may involve your employer matching 50% of your contribution up to 4% of your pay. That’s $0.50 for every dollar you contribute up to 4% of your pay.

Let’s look at an example. If you make $60,000 a year, and your employer does a 50% match on up to 4% of your salary, 4% is $2,400 and their match would be $1,200. A dollar-for-dollar match would be $2,400.

A 401(k) match of any kind is considered part of your employer compensation plan, and you can see why it’s a benefit you shouldn’t overlook when you’re job hunting.

Solo 401(k)

A solo 401(k) is a retirement plan created for self-employed business owners who don’t have any employees, and you can make contributions as both the employer and employee. Contribution limits go up to $58,000 in 2021, with an additional $6,500 catch-up contribution if you’re 50 or older.

One of the things many self-employed people like about saving in solo 401(k) vs. IRA is that your spouse can make contributions if they draw income from your business. Spouses are the only other employees who can use your solo 401(k). You can also make Roth or traditional contributions to your solo 401(k).

401(k) distributions

Distributions from a 401(k) are taxed at your income rate — you made contributions with pretax dollars so that taxes need to be paid on the other end. You can take distributions on your 401(k) without any penalties as long as you’re 59 1/2 or older. The penalty is generally a 10% tax.

You must start taking minimum disbursements beginning at age 72.

Another feature is that you may be able to take a loan or hardship withdrawal from your 401(k). Repayments on a 401(k) loan are made as deductions from your paycheck.

How to invest for retirement with a 401(k)

Your employer is responsible for setting up your 401(k), and they’ll help enroll you upon employment or after you’ve worked for the company for a certain period. You will set up your contributions, and your money will be invested through the company’s sponsor. They will likely have a line-up of mutual funds designed to meet different risk tolerances.

If you’re self-employed, check out this list 5 Best Solo 401(k) Providers for 2024.

IRA vs. 401(K): Which Is Best for You?

The reality is that not everyone will have access to each of these plans, so the best way to decide between them is to start with what’s available.

If your employer offers a 401(k) match, start putting your retirement savings there. Your employer match isn’t just free money — it’s part of your compensation, so take advantage of it.

Because you’re not in complete control of what’s in your 401(k), the fees are often higher than an IRA. So contribute enough to receive the full match from your employer, then contribute as much as you can to an IRA. If you still have funds to put towards retirement, you can go back to your 401(k) and make more contributions. Or you can defer extra funds towards trading stocks or other investments.

If you don’t have access to a 401k or your employer doesn’t make matching contributions, then you can start saving for retirement in an IRA. It’s generally the better option to contribute the maximum amount to your IRA because you have access to nearly unlimited investment options, fees can be lower, and you have more control over your investments.

Once you’ve maxed out your IRA contribution, then you can go back and direct funds to your 401(k). Another option is to invest additional funds through an individual taxable account, and there’s a long list of great stock brokers and online investment apps to get started with.

Learn more in 10 Best Investment Apps of 2024.

IRA vs. 401(k): The Final Word

Investing through an IRA or 401(k) are both great ways to set money aside so you can focus on enjoying your retirement years. You honestly can’t go wrong with either.

If both are available to you, start investing in your 401(k) if your employer offers a match. Then put additional funds in an IRA. If a 401(k) isn’t available, you can invest in an IRA and put additional funds in an individual taxable account.

The bottom line is that there are retirement plans for everyone. Now that you know the differences, it’s time to start saving.