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

When you’re ready to start saving for retirement, the first type of account you’ll encounter is probably a 401(k). While this is a good place to start, it isn’t the only account you can use to save for retirement. 

Individual retirement accounts (IRAs) and employer-sponsored 401(k) plans are both tax-deferred retirement plans. This means you won’t pay taxes on the money you invest now — but you will pay taxes later when you’re ready to retire. 

Depending on your tax bracket, this could leave you with a sizable tax bill during retirement.

But some IRAs — like a Roth IRA — come with different tax benefits. With a Roth IRA, you pay taxes now, but when you retire you’ll be able to make withdrawals tax-free. 

This can all get confusing, so let’s review the key differences between these accounts and how to know which one is right for you.

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What Is a 401(k)?

A 401(k) is an employer-sponsored retirement savings plan. Contributions are usually deducted from your paycheck automatically. You never see the money, which can make it easier to make investing a habit.

Employers who sponsor a 401(k) may also offer a match. This is free money that your employer will deposit into your account on your behalf, up to a specific dollar amount. 

The match is typically up to half of your contribution. For example, if you contribute 6% of your salary, your employer will match up to 3%. 

Most 401(k) plans come with pre-picked investment options. You can choose from a variety of different funds based on your personal risk tolerance and financial goals. 

Your company might also offer financial literacy tools that can help you pick the right funds to invest in.

What Is an IRA?

A traditional IRA is a retirement account that anyone who earns an income can open. 

With an IRA, you can choose what to invest in. This can include riskier assets like equities or more conservative assets like certificates of deposit (CDs) and bonds.

There is also a special type of IRA called a Roth IRA that comes with additional benefits. This type of account is tax-advantaged (rather than tax-deferred), which means you pay tax on the money before you invest it.

When you’re ready to retire, withdrawals from a Roth IRA are made tax-free.

READ MORE: How Much You Need to Retire

What 401(k)s and IRAs Have in Common

Both 401(k)s and traditional IRAs are tax-deferred retirement savings plans. 

This means you can deduct your contributions to reduce your adjusted gross income (AGI) — and your tax bill. 

There are limits to how much you can contribute to both. Also, both plans have required minimum distributions. This means that when you hit age 73, you’re required to make withdrawals from your account — that’s when you’ll pay taxes. You’ll pay tax on the withdrawals as if it were ordinary income from working a job.

Both plans also have early withdrawal penalties. If you try to make a withdrawal before age 59½, it’ll be treated like income. You’ll pay income tax on it, as well as a 10% penalty.

You can have an IRA even if you’re already enrolled in your company’s 401(k) plan.

The Differences Between a 401(k) and IRA

There are several distinct differences between an IRA and 401(k) — namely who they’re available to, how much you can contribute, and how you can invest.

Access

The biggest difference between a 401(k) and an IRA is how you access each account. 

401(k)s are typically sponsored by your employer. When you begin a new job, you’ll be given the option to enroll in a 401(k) plan. Often, an employer match is part of it. That means your employer will contribute to your 401(k) on your behalf up to a specified dollar amount.

IRAs are available to anyone who earns an income. This makes them a bit more accessible than 401(k)s, especially if your employer doesn’t offer a retirement savings plan. 

You can open an IRA at a brokerage firm or a bank. While an IRA issued by a bank allows you to earn interest, an IRA with a brokerage firm allows you to purchase securities like stocks or bonds. 

Unlike 401(k)s, IRAs don’t come with an employer match unless it’s sponsored by a small business, like a SIMPLE IRA plan.

Contribution limits

401(k)s and IRAs also have different contribution limits.

With a 401(k), you’re allowed to contribute $23,000 per year. The combined employee and employer contribution for a 401(k) is $69,000. 

With an IRA, the contribution limits are significantly less. For an IRA, you can contribute $7,000 per year (or $8,000 if you’re over 50). 

Investments

Another difference between an IRA and 401(k) is what you are allowed to purchase with your money. 

The options offered in a 401(k) are usually limited. You are typically offered a prospectus with different funds to choose from, but rarely do you get the chance to handpick the stocks or bonds you want to invest in.

IRAs give you a little more freedom. You can pick individual securities, or you can pick bundled securities like exchange-traded funds (ETFs) or mutual funds. This allows you to be more active in managing your portfolio, allowing you to minimize fees and grow it quickly.

READ MORE: Active vs. Passive Investing: Which Is Best?

When To Use a 401(k)

You’ll want to use a 401(k) if it also comes with a match. 

Even though the match isn’t paid out like your salary, it is factored into your overall compensation package. It’s money you’re entitled to so long as you fulfill your employer’s requirements to earn the match. 

These requirements might be contributing a certain percentage of your income or staying employed with the company for a specific period of time. 

Make sure you take advantage of the match, or else you’ll be leaving free money on the table. 

@erikakullberg Which investment vehicle? #401k #rothira #erikataughtme ♬ original sound – Money Lawyer Erika

You may also want to consider using a 401(k) as part of your tax strategy. Contributions to a 401(k) lower your taxable income, which could result in significant tax savings. 

For example, if you make $50,000 and contribute $10,000 to your 401(k), your taxable income for the year is $40,000. This moves you to a lower tax bracket, decreasing your tax bill.

If you are just getting started with investing and don’t know where to begin, a 401(k) is probably your best option. Your employer will automatically deduct your contribution from your paycheck, so you won’t be tempted to spend it. 

While you won’t get to choose what you invest in, the funds your employer offers you eliminate some of the friction that might come from having to decide what to choose.

When To Use an IRA

An IRA is a good option if you want more control over your investment choices. 

With an IRA, you can invest your money however you want. Because you have a wider array of assets to choose from, you can reduce the amount you pay on fees while also having the opportunity to invest in high-growth companies.

A Roth IRA, in particular, can complement a traditional savings plan. While a Roth IRA doesn’t come with the same short-term tax benefits, it does allow you to begin building wealth tax-free. 

If short-term tax implications aren’t a primary concern for you, a Roth IRA can be useful for long-term growth.

FAQs

Is it better to have a 401(k) or an IRA?

Deciding between a 401(k) and an IRA is a personal choice. There are pros and cons to each. 401(k)s usually come with a match and are easier to manage, while IRAs give you more control over how you invest your money. 

You aren’t limited to having one account over another, which means you can contribute to both if you’d like to.

Can I have both an IRA and a 401(k)?

Yes, you can have both an IRA and a 401(k). To make contributions to both, you’ll need to meet the eligibility requirements and stick to the contribution limits. 

For 2024, you can save $23,000 in a 401(k), up to a combined $69,000 with your employer’s match. For IRAs, you can contribute $7,000 if you’re under the age of 50 or $8,000 if you're older.

The only limitation to having both is maintaining a Roth IRA as a high-income earner. If you make $153,000 or more per year (or $228,000 as a married couple), you cannot contribute to a Roth IRA.

TL;DR

A 401(k) is usually sponsored by your employer, while anyone with income can open an IRA. 

With an IRA, you can pick where to invest your money, while 401(k)s are less flexible — but may be appealing if you’re new to investing. 

Which one is best for you comes down to what’s more accessible and how comfortable you are with choosing your investments.

For more lessons on investing and saving for retirement, check out these episodes of the Erika Taught Me podcast:

• The Missing Piece in 99% of Financial Advice
• How To Invest for Beginners
• Money and Investing Pitfalls to Avoid

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