As you start the plan for your retirement, understanding the difference between 401k and IRA accounts will be helpful. After all, you want to do more than just a savings account for your retirement, and learn to invest for your future.
As we discuss IRA vs 401k options, you'll notice both are common ways to save and invest for retirement, and each offers distinct advantages.
Today we will take a closer look at both of these types of retirement savings accounts, and find out what is the difference between a 401k and IRA. Plus, how to include the best fit in your retirement plans.
What is a 401k?
First, let’s take a closer look at a 401k and find out what it is. You'll then understand if you're eligible for a 401k and how it can affect your retirement.
A 401k is an employer-sponsored plan
The first thing to know is that 401ks are employer-sponsored retirement plans, which is a huge difference between 401k and IRA accounts.
Many companies offer access to these retirement accounts as a perk of working with them. Generally, 401ks invest in mutual funds, stocks, bonds, index funds, and other investment options.
You can set up a portion of your paycheck to automatically contribute to your 401k. When you do this, you’ll enjoy the fact that your contribution is made with your pre-tax dollars.
Additionally, some employers will send contributions to your 401k, which is pretty much free money, a major difference between IRA and 401k accounts. This is known as a company “match.”
Typically, the employer will clearly share what their matching policy entails. In some cases, employees might enjoy a full match of their contributions up to 3%. In others, you might receive a match for half of the funds you contribute.
The rules will vary by the company, but it should be relatively easy to find this information. If you aren’t sure whether or not your company offers a 401k, then check with Human Resources to find out. They’ll have all the details you need to set up an account.
Accounts similar to a 401k
If you aren’t able to contribute to a 401k, don’t worry! There are other employer-sponsored retirement accounts that you might be eligible for.
A few include a 403(b) and a 457(b). And even without any of these employer-sponsored plans, you still have options to build your retirement savings.
How much can you contribute?
If you are eligible to contribute to a 401k, there are some limitations on how much you can contribute. It is important to note that these limits are set by the IRS, not your employer.
In 2023, employee contributions are at $22,500 to your 401k. If you're over the age of 50, you can add an additional $7,500 per year. Keep in mind that the IRS can change these limits each year.
Over 20k is a great amount to start with and offers you the flexibility to put quite a bit of money away for the future. And as far as IRA vs 401k, a 401k may allow higher contributions, depending on the type of IRA.
As you contribute money, you will not be able to pull it out until age 59.5. There are some exceptions (like using a 401k withdrawal for a home purchase).
But you will need to jump through many hoops to withdraw any funds before the designated retirement age of 59.5. Plus these withdrawals might not be a good idea and can result in an early withdrawal penalty.
Is a 401k an IRA?
You may be wondering, is a 401k an IRA? While they are both types of accounts that help you save for retirement, there are distinct differences. A 401k is offered by employers, while an IRA is available for anyone.
What is an IRA?
Knowing more about the IRA can aid you in deciding what's right for you. This type of retirement account may be a good fit for you depending on your retirement needs. With IRAs, you have the opportunity to invest in mutual funds, ETFs, stocks, bonds, and more.
Is an IRA a 401k?
An IRA is a retirement option that is not employer-sponsored. As the name suggests, an IRA is not an employer-sponsored plan, a major difference between 401k and IRA accounts.
With both of these accounts, you should be aware that there are rules surrounding your withdrawals. If you want to withdraw funds before age 59.5, then you might run into an additional 10% tax for the early withdrawal.
However, there are exceptions including withdrawing the funds for qualifying education expenses, first-time homebuyers, and more.
How much can you contribute to an IRA?
Anyone that is eligible is able to contribute to an IRA, but there are some limitations. You’ll have the option to contribute up to $6,500 to an IRA for 2023. But if you are over age 50, then you are able to contribute $7,500.
Types of IRAs
As you explore your options, you’ll find that there are two common types of IRA: Roth and Traditional. There are also other IRA types you might come across depending on circumstances. Here’s a closer look.
A traditional IRA offers the same tax-deferred benefits as a 401k. That means that the money you contribute to this retirement uses pre-tax dollars. Your traditional IRA contributions will not be taxed until you withdraw them in the future. The maximum contribution amount is also much lower than the 401k which we will discuss below.
A Roth IRA offers a different kind of tax benefit. With this account, you pay taxes on the dollars that you contribute to the account. However, you will not pay taxes on the withdrawals of your earnings or contributions in retirement.
If you want to contribute to a Roth IRA, then you’ll need to earn less than $138,000 for individuals (after which there are restrictions) or less than $228,000 as a married couple filing jointly. Be mindful of these income limits if you choose this route.
SEP IRAs (simplified employee pension)
A SEP IRA is an investment vehicle that allows employers to contribute to their employee's retirement.
A SEP IRA is pretty unique in that it's available to those that are self-employed as well as companies, and the contribution limits are high - up to 25%. But the downside is it's more challenging for employees to contribute to this plan.
A SIMPLE IRA is otherwise known as a Savings Incentive Match Plan for Employees, and it's a good option for businesses that are new or small because it doesn't require the extra fees some other retirement plans do. Employees may contribute to this kind of retirement account.
As you've seen, there are several IRA options, and you can learn about others here. Wondering, "How many IRAs can I have?". We break it down in this article.
What is the difference between 401k and IRA?
Now that you have a better understanding of these retirement accounts, it's time to dive in to find out what is the difference between a 401k and IRA account.
Eligibility to contribute
The biggest difference between IRA and 401k options is your eligibility to contribute. With a 401k, you would need to work for an employer that offers a retirement account in order to contribute.
With an IRA, you don’t need the sponsorship of an employer to set this up. IRAs may be a better choice for self-employed people who cannot use a 401k, though there are other options for business owners, such as a solo 401k.
Another major difference between the 401k vs IRA is the annual contribution limits. A 401k has higher contribution limits than the IRA contribution limits. That might factor into your retirement planning depending on your retirement timeline.
Investment opportunity difference between 401k and IRA
With a 401k, your investment options are limited to what your employer chooses. This is a major difference between 401k vs IRA accounts.
In some cases, your employer may have picked less than ideal investment options. In others, you might find that your investment goals align perfectly with the chosen picks. If you have a specific portfolio balance in mind, these limitations could be a problem.
With an IRA on the other hand, you have the complete freedom to choose your investments. You aren't limited by your employer’s choices. Instead, you can pick the investments that suit your retirement goals.
Tax differences between 401k and IRA
When you contribute to a 401k or traditional IRA, you will use pre-tax dollars. But when you withdraw the money, the funds are taxable income and subject to income taxes.
You want to make sure that you account for the tax bill in your retirement plans. Otherwise, it can be an unpleasant surprise for your budget.
A Roth IRA requires that you make contributions after taxes are taken out. That said, when you want to take out your funds in retirement, you will not need to worry about paying taxes on any withdrawals. Your money will be tax-free at this point.
Which should you contribute to? The 401k or IRA?
Both of these retirement accounts have their advantages and drawbacks. However, both are useful tax-advantaged accounts that you can build a robust retirement portfolio within.
Should you have a 401k and an IRA?
If possible, it's a good idea to contribute to both of these accounts as you plan for retirement. But that is not always possible since you may not have access to a 401k.
If you do have access to a 401k where you can make employee contributions for an employer match, then make sure to contribute at least enough to receive the full match.
Although you might not be able to add the maximum for your contribution limits for a 401k and IRA, it is important to consider both in your retirement plans. You can use the different tax advantages to craft a portfolio that works best for your retirement dreams.
Now you know the difference between 401k and IRA, it's time to invest!
401ks and IRAs are both useful retirement accounts. However, the best combination of retirement accounts will depend on your unique situation and retirement goals.
Now that you have a better understanding of these accounts, and know the difference between 401k and IRA accounts, consider the advantages of 401k vs IRA as you map out your retirement savings plan.
Keep learning about retirement planning as you build the perfect plan for your money goals. Take action today and work towards your retirement goals with the right account to help you along the way. Our podcast, Clever Girls Know, will help you find out more about all things money.