A 401(k) and Individual Retirement Account (IRA) are both retirement investment vehicles, but they don’t function quite the same.
While either will get you closer to funding your golden years, one might be more advantageous depending on your situation.
Unfortunately, you may not even have a choice between the two.
Here are the differences between a 401(k) and an IRA and how to tell which one might be better for you.
A 401(k) is an Employer Sponsored Retirement Plan
The reason I mentioned that you might not have a choice when it comes to picking a 401(k) or IRA is because 401(k)s are employer sponsored retirement plans. That means your employer must offer a 401(k) as part of your benefits package for you to have access to one.
A lot of smaller companies might not offer 401(k)s. That was the case for the first few employers I had, and as a result, I didn’t start saving for retirement until a few years after I landed my first full-time job.
The awesome bonus of 401(k)s over IRAs is that employers can also choose to match your contributions up to a certain percent. That means you get free money! This bonus is something that many young workers aren’t aware of because it tends to be in the fine print of their benefits package.
Ask your HR department (or whoever manages the 401(k) package at your company) for more information on this, as you don’t want to miss out and leave money on the table.
Anyone Can Open an IRA and Fund it
Anyone can open an IRA as long as they have earned income. You don’t need an employer to open an IRA for you. So no excuses for skipping out on retirement contributions if a 401(k) isn’t available to you!
However, there are exceptions you need to be aware of that are beyond the scope of this article. Suffice to say if you earn over a certain amount, depending on your tax filing status, you may be limited to how much you can contribute.
But if you’re a younger and still working your way up the ladder, you probably don’t have to worry about it as you tend to need a modified adjusted gross income of over $100,000.
If you want to look into it more, the IRS explains the limits here.
Contribution Limits are Different
Speaking of contributions, as of the 2016 tax year, you may contribute up to $18,000 in a 401(k). You’re limited to a contribution of $5,500 in an IRA.
$18,000 might seem like a lot, and the truth is, it might not be wise to focus on maxing out your 401(k). Not all 401(k)s are made equal.
For example, some come with a horrible selection of funds with extremely high fees. In this case, you might be better putting your money elsewhere so you can get a better return.
If this is the case for you, the good news is that you can contribute up to your employer match in your 401(k) and then switch over to contributing the rest of your money to your IRA. You don’t necessarily have to choose between one or the other.
Tax Advantages Are Different
401(k)s and traditional IRAs function similarly here – the difference is in how a Roth IRA is treated.
Contributions to 401(k)s and traditional IRAs are tax-deductible – they give you an immediate benefit when you file your taxes. When you contribute money to either of these accounts, your taxable income decreases since the contribution is made with pre-tax money.
401(k)s and traditional IRAs are tax-deferred, which means that you’re taxed when you withdraw the money in retirement. The benefit from this is that if your taxable income during retirement is lower, you might pay less than you would by saving in a Roth.
Tax-deferral also comes in handy when it comes to interest, as your money can compound freely. By contrast, you have to pay taxes on the interest gained in a savings or checking account.
Tax advantages with a Roth IRA are different. Instead of being taxed when you withdraw the funds, you’re taxed immediately upon making a contribution. However, withdrawals are tax-free.
By the way – some companies offer Roth 401(k)s, which work similarly to a Roth IRA, in case that’s an option for you!
Which is Better? A 401(k) or IRA?
The answer to this will greatly depend on your situation. Again, you might find that your 401(k) is abysmal. Maybe your employer doesn’t offer matching contributions, or maybe the match is limited. Or, maybe you don’t have access to a 401(k).
In any case, you can always open an IRA and make contributions to it, or contribute to both.
So then you run into the question: which is better, a traditional IRA, or a Roth IRA?
And again, the answer depends. I’m not a professional, and I don’t know your individual situation, so I can’t give you a definitive answer.
However, it’s been widely accepted that Roth IRAs can be a better choice for young adults. This is due to the fact that the money is tax-free when withdrawn.
The assumption is that you’re earning less right now while you build your career, so you’re likely in a lower tax bracket. As you age, your earnings will increase, and you’ll be in a higher tax bracket come retirement. Those withdrawals being tax-free will help lessen the burden.
Of course, this may not be the case for you, so you have to use your judgment. At the very least, you have a baseline for knowing which vehicle is better to invest in, so you can research more on your own.
There are other differences worth noting, too. For example, traditional IRAs require you to start taking distributions once you’re 70 1/2 years old, but maybe you have no reason to! Roth IRAs don’t require you to take distributions at any age, which means your money can continue growing tax-free until you’re ready to withdraw it.
Additionally, contributions to Roth IRAs can be taken before you’re 59 1/2 years old, without penalty, whereas you’ll pay a 10% penalty if you withdraw funds from a 401(k) or traditional IRA earlier than 59 1/2.
However, if you have a qualifying reason for a withdrawal, such as being a first-time homeowner, you can withdraw up to $10,000 from your traditional IRA without penalty. You must wait 5 “tax” years after making the first contribution to your Roth IRA before you can withdraw for a qualified expense.
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As you can see, there is a lot of information to consider when thinking about which vehicle you should use for your retirement savings. There are so many little details when it comes to taxes that it can be a little overwhelming, but hopefully this provided a good baseline for you.
If you’re concerned about optimizing your taxes, I recommend speaking with an accountant or finance professional who can walk you through the best option for your situation.
Which is your pick – 401(k), traditional IRA, Roth IRA, something else? How did you come to that decision? Are you saving for retirement?
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I once had a job where I had a Roth 401(k). I felt like it was the best of both worlds.
Nice! It sounds like a great option to have.
Great overview of the options! We have a 401k, traditional IRA and Roth IRA. We started the Roth when we were younger as a combined college/retirement savings vehicle. We’ve since stopped contributing to it and moved to a traditional as we’ve gotten older to take advantage of the tax savings.
That sounds like a great strategy, Amanda!
Awesome detailed comparison! I find that a lot of young adults confused 401ks and IRAs often. My company doesn’t match contributions but we have an awesome profit sharing plan. Typically I would contribute to my 401k to get the match and then contribute any additional amount to an IRA (of course, keeping with in the limits). My 401k has pretty low fees and a wide range of investment options. So I contribute more there because it comes right out of my paycheck.
I think another advantage a 401k has is that it is fully protected from bankruptcy claims by creditors compared to an IRA which has a protection cap of about $1 million.
I would note that, if you’re young but expect to make a high household income in the future (young lawyers, medical residents, etc.), you might want to reconsider funding an IRA. The reason being that those of us with high household incomes in the future can’t fund a Roth IRA directly, and will need to keep IRA space open in order to utilize a backdoor Roth IRA.
For myself and my fiance, we do not fund any IRAs, simply because we will have a high household income and want to keep the flexibility of being able to contribute to a backdoor Roth if we decide. Probably beyond the scope of this post, of course, but just thought it’d be a nice reminder for millennials early in their careers that expect to make much more later.
Hey Erin,
Great write-up! You covered most of the bases, but like you said, it’s personal for everybody and every situation. It’s impossible to cover every situation in one article, but I think you came as close as you can!
Like the majority, I recommend a Roth IRA for young people, since the growth will likely well exceed what you put in at a young age. Of course, this is assuming you are putting it in growth investments. If it sits in a money market account, it won’t really matter because there isn’t going to be much, if any, growth. I see this all the time with the Thrift Savings Plan (TSP), which is the 401k equivalent for federal employees. Since the new Roth TSP was introduced, everyone is flocking into it; however, the majority of people are leaving it in the government-secured fund that it automatically deposits your money into — basically a savings account. So they’re surprised to see that in 10 years, they’ve had little to no growth.
Do your research as far as investment options and make sure your money is actually growing. I can’t stress this enough. As long as people actually do the research, I recommend putting enough in your 401k to get the match (if there is one), and then maxing out your IRA (since you have way more options for investment), and finally maxing out your 401k once your IRA is maxed out.
Also, don’t forget that stay-at-home spouses can contribute to an IRA. As long as you file a joint tax return, a stay-at-home spouse can contribute the same as an employed person can. Take advantage of that — that’s double the contribution limits!
So my personal suggestion is usually this:
1. Put enough in your 401k to get the full match
2. Max out your IRA (Roth general preferable)
3. Max out your 401k
If you’ve done that, you should be sitting pretty! Make it as far down the list as you can. That’s just my two cents!
Cheers,
Kalen
I miss my employer-sponsored 401k. It’s worth contributing the minimum to get any qualifying match. I also invest in a Roth IRA, that way I can choose direct stocks or funds that are not part of the 401k basket.
As a Canadian, I’ve always compared the American 401(k) to our RRSPs and the IRA to our TFSAs. I wasn’t clear on the difference between traditional and Roth IRAs. Now I am, so thanks for that! I like the international flavour of pf blog posts. There are subtle and not-so-subtle variations from country to country.
Great overview Erin! I feel that unless you’re in the 10% tax bracket, you should be contributing as much as you can to your 401k plan if it’s a decent one. The match is nice of course, but what really moves the needle is contributing more and letting compound interest do its thing. Tax savings and compound interest are a powerful combination.
The other thing I like about 401k contributions is that they are usually taken out of your check automatically. This is the best system to have set up because it prevents you from wasting the money otherwise.