Young couple budgeting in their home.

401k Vs. IRA: What’s The Difference And How Do I Choose The Right Option?

7-minute readSeptember 21, 2020

Retirement planning company Vanguard says if you save about $4,500 each year starting when you turn 20 and keep doing this during a career of 45 years, the odds are good that you'll collect $1 million in savings by the time you retire at age 65. If you start saving at age 30, you'll need to put away about $9,000 each year to have the same chance.

The message is clear: It's best to start saving as soon as possible for your retirement. But which retirement savings vehicle should you use?

You have plenty of options: Your employer might offer a 401(k) plan you can invest part of your paycheck in each time you’re paid. You can also choose to invest in an individual retirement account, better known as an IRA. These come in two main types: traditional or Roth. Both allow you to invest your dollars on a regular basis, with the hope that they grow each year, thanks to compound interest.

Both types of retirement accounts come with tax advantages: With a 401(k) or traditional IRA, your deposits, up to certain limits, are not counted as taxable income, something that will lower your income tax bill. A Roth IRA works differently: You'll receive your tax benefit once you start making withdrawals from it.

Which choice is best for you? That depends on a host of factors, such as whether you work for a company that offers its own retirement savings plan, how much money you make each year and when you plan to retire.

Here’s a look at the differences, advantages and disadvantages of IRAs and 401(k) plans.

401(k) Vs. IRA: A Summary

Both 401(k) plans and IRAs are examples of retirement savings vehicles. Both give you the option to make regular contributions toward your retirement nest egg. But there are several key differences between these two options.

What Is A 401(k)?

A 401(k) plan is only offered by an employer to its employees. If you work at a company that offers one, you decide whether to participate and how much you'll be depositing from each paycheck. You might decide to contribute 10%. If you are paid $2,000 twice a month, you’d deposit $200 from each paycheck, or $400 a month.

Your employer will invest your contributions into a mix of funds, with the hope that your money will grow depending on the performance of these funds. Some employers offer a matching program. In such programs, your company will contribute an additional amount of funds into your 401(k) account at the end of the year. If you deposit $4,000 and your company matches 50% of your contributions, it will deposit an extra $2,000.

What Is An IRA?

An IRA is similar to a 401(k) plan, only it isn’t offered by your employer. You set up and contribute to an IRA on your own. Many people invest in an IRA because their employers don’t offer 401(k) programs. You decide how much to invest in an IRA each year. That money is then deposited in a mix of funds, with the hope again that these funds will increase in value and your savings will grow steadily.

There are two types of IRAs: traditional and Roth. The main difference between the two is when your tax breaks kick in. With a traditional IRA, your yearly contributions are tax deductible, lowering your taxable income. With a Roth IRA, the withdrawals you make during your retirement years are not taxed, but you don’t receive a tax break when initially depositing this money.

There is one big similarity between IRAs and 401(k)s: They are both defined contribution plans. These are retirement savings vehicles in which participants – workers or individuals – deposit money on a regular basis. This is different from a pension, also known as a defined benefit plan. If you receive a pension, your employer agrees to pay you a certain amount of money each month throughout the rest of your life. Pensions have become rare, while defined contribution plans have grown in popularity.

The big difference between these two types of retirement vehicles is that a 401(k) is set up through your employer. You set up an IRA on your own, working with a bank, brokerage or financial services company such as Vanguard, Fidelity or SoFi.

Pros And Cons: IRA

Pros

Tax benefits: If you take out a traditional IRA, your contributions to it might be tax deductible, depending on your income. If you’re single and your modified adjusted gross income is $64,000 or less, you can deduct your full contribution to a traditional IRA for the 2019 tax year. A married couple filing jointly can claim the full deduction if their modified adjusted gross income is $103,000 or less. Roth IRAs work differently: Your initial contributions are not tax deductible. But you won't pay taxes on your withdrawals. With a traditional IRA, you’ll be taxed when you withdraw money.

Diversity: With a traditional and Roth IRA, you'll diversify your investments. That's because when you contribute to one of these vehicles, your dollars can be funneled to a variety of stocks, bonds, mutual funds and exchange-traded funds.

Tax-free growth: Both Roth and traditional IRAs allow your investments to grow on a tax-free basis. Once you’ve deposited your money, you won’t pay taxes on any gains your money earns or dividends it pays out.

Cons

Limits: You can’t deposit an unlimited amount of money in a Roth or traditional IRA. For 2020, the most you can contribute to an IRA is $6,000. That figure increases to $7,000 if you are 50 or older. Once you reach the age of 70 1/2, you can no longer contribute to a traditional IRA, though you can still deposit money in a Roth IRA.

Penalties: You might also face hefty penalties depending on when you withdraw money from an IRA. You'll be hit with a penalty of 10% of the amount you withdraw from a traditional IRA if you take out that money before you reach the age of 59 1/2. You'll also have to pay taxes on the money that you withdraw. With a Roth IRA, you can withdraw money equal to the contributions you've made without paying taxes or penalties. You can only withdraw earnings from a Roth without facing penalties if you've reached the age of 59 1/2 and you've held onto the account for at least 5 years.

Required withdrawal: Once you reach the age of 70 1/2, you’re required to begin making withdrawals from your traditional IRA, even if you’d rather not. You don’t, though, have to make withdrawals from a Roth IRA at any age.

Pros And Cons: 401(k) Plans

Pros

Matching contributions: Some employers will match a percentage of your yearly contributions into a 401(k) plan. These extra dollars at the end of the year are like free money. Not all employers offer a matching contribution, but if yours does, be sure to invest in your company’s 401(k) plan to take advantage of it.

Higher contribution limits: In 2020, you can contribute up to $19,500 in a 401(k) plan. If you’re 50 or older, you can contribute an additional $6,500.

Tax advantages: The contributions you make to your 401(k) aren’t taxed. This lowers your taxable income. Say you earn $60,000 a year but contribute $8,000 to your 401(k). Your taxable income is now $52,000 instead of $60,000.

Federal protection: A federal law called the Employee Retirement Income Security Act of 1974 provides protection for 401(k) plans, setting a minimum standard that employers must follow when operating a plan. This law states that employers must provide you basic information about your plan's features and the right to sue if your plan is mismanaged.

Cons

Penalties: As with a traditional IRA, if you withdraw money from your 401(k) before the age of 59 1/2,you will pay a penalty of 10% of what you’ve withdrawn. You’ll also have to pay taxes on the money you take out.

Forced withdrawals: You are required to begin withdrawing money from your 401(k) when you hit 70 1/2.

The withdrawal tax hit: Once you begin taking money out of your 401(k), your withdrawals are taxed as if this money was regular income.

How Do I Choose Between A 401(k) Plan And An IRA?

Here’s some good news: You don’t really have to choose between an IRA and a 401(k) plan. You can invest in both – up to your contribution limits – each year.

But if you want to invest in just an IRA or a 401(k) plan, here are some factors to consider:

My employer offers a 401(k) plan with matching contributions: You should definitely take advantage of this option. That matching contribution, usually awarded at the end of the year, is like free money. Don’t pass that up.

My employer offers a 401(k) plan without matching contributions: A 401(k) plan without a matching feature isn’t quite as good. But you should still participate in your employer’s plan. Investing in a 401(k) plan is easy: The money is automatically withdrawn from your check, so you don’t have to think about it. Also, 401(k) plans allow you to deposit more each year than does an IRA.

My employer doesn’t offer a 401(k) plan, or I don’t qualify for it: In this case, you should invest in a Roth or traditional IRA. You still need to save for retirement. Not putting money away in an IRA could leave you with a financial shortfall once you reach retirement age.

For more articles like this one, check out our personal finances learning center.

Apply For A Mortgage Online

NMLS #3030