Understanding Key Differences Between an IRA and a 401(k)

April 22, 2022

In an era where many jobs in the private sector no longer offer traditional pension plans, how do you build the savings you’ll need to retire comfortably? It often makes sense to choose a tax-advantaged retirement plan on your own. There are multiple types of retirement plans which are designed to help you save by offering different tax benefits; your choice of plan depends on your unique employment and financial situation.

 

This article takes a close look at the key differences between two of the most commonly held retirement plans: individual retirement accounts (IRAs), which are generally available to anyone, and 401(k)s, which are tied to the company an employee works for – though not all employers offer them.

 

What Is an IRA?

An IRA is a tax-advantaged savings plan that can help individuals proactively save for retirement. They’re available to anyone with earned income and are usually opened through qualified financial institutions, such as banks, life insurance companies, or investment companies. As the name “individual retirement account” suggests, IRAs are typically opened and managed by individuals themselves, not through an employer. There are two main types of IRAs, Traditional and Roth, each of which offer different tax advantages.

  • Traditional IRAs are funded with pre-tax dollars, meaning you won’t pay income taxes until you withdraw funds in retirement. Contributions are tax-deductible up to certain income limits. There are no age or income restrictions to contribute to a Traditional IRA, and you can start withdrawing funds penalty-free at age 59-½. Note that individuals ages 72 or older are required to take annual minimum “distributions,” or withdrawals.1
  • Roth IRAs are funded with post-tax dollars, or the income you’ve already paid taxes on. Contributions are not tax-deductible, but you won’t pay taxes on qualified withdrawals. Roth IRAs have strict income eligibility requirements2 but do not require account owners to ever take annual minimum distributions. Instead, individuals can withdraw contributions at any time, tax-free.3 Earnings can be withdrawn tax and penalty-free at age 59-½ – provided five years have passed since you made the first contribution to your Roth IRA.4

Both Traditional and Roth IRAs have lower annual contribution limits than 401(k)s. As of 2022, total annual IRA contributions cannot exceed $6,000, or $7,000 for those ages 50 and older.5

 

What Is a 401(k)?

A 401(k) is an employer-sponsored retirement plan. If an employee opts in to a 401(k), contributions are deducted from their paycheck and invested in mutual funds or other investments. Employees can usually pick their investment choices from a list of available options.

 

Not all employers offer 401(k)s and, among the ones that do, terms may be different. For example, many employers will match a percentage of your contributions to help you save for retirement. In other words, all contributions you make up to a certain percentage, such as 4% of your salary, would be matched by your employer and deposited in your 401(k).

 

Like IRAs, there are two primary types of 401(k)s: Traditional and Roth.

  • Traditional 401(k)s are funded with pre-tax dollars, meaning the money comes from your paycheck before income taxes have been deducted. Taxes are then paid when funds are withdrawn. Individuals can withdraw funds penalty-free starting at age 59-½, and required minimum distributions must be made starting at the age 72 and up.6
  •  

  • Roth 401(k)s are funded with post-tax dollars, meaning the money comes from your paycheck after income taxes have already been deducted. Therefore, qualified withdrawals are tax-free. Withdrawals can be made penalty-free starting at age 59-½. Unlike Roth IRAs, Roth 401(k) owners are typically required to take minimum distributions at the age of 72 and up.7

For both Traditional and Roth 401(k)s, contribution limits are significantly higher than that of IRAs. As of 2022, individuals can contribute up to $20,500, or $27,000 if age 50 or older.8 Eligibility to contribute to a 401(k) is not dependent on income limits.

 

Key Differences Between an IRA and a 401(k)

The following table provides a quick overview of the general differences between Traditional and Roth IRAs and 401(k)s.

 

  Traditional IRA Roth IRA Traditional 401(k) Roth 401(k)
Who maintains account? Individual Employer
Annual contribution limit for 2022 $6,000 ($7,000 if age 50 or older) $20,500 ($27,000 if age 50 or older)
Income limits to participate? No Yes No
Are contributions taxed? No Yes No Yes
Are withdrawals taxed? Yes No Yes No
Employer match? N/A Yes, if plan allows
What age can distributions begin? 59-½

Any time

(excluding earnings)

59-½
Required minimum distributions? Yes, age 72 and above No Yes, age 72 and above

 

Can I Have Both an IRA and a 401(k)?

As long as you’re qualified and observe income and contribution limits, you can have both an IRA and a 401(k) account. To determine your eligibility, consult with your financial or tax advisor.

 

What About Rollovers?

It's possible to transfer, or rollover, the money saved in one retirement plan to another. For example, if you have a 401(k) and switch employers, it's possible to "rollover" your previous company's 401(k) to your new employer’s 401(k) or to an individual IRA that you hold at another institution. This way you can continue to actively manage your retirement savings and track the growth of your nest egg. To ensure rollovers occur penalty-free, it’s imperative to carefully follow IRS guidelines.9,10

The Bottom Line

 

IRAs and 401(k)s both offer tax incentives and options that make it easier to save for retirement. IRAs are available to help individuals establish their own retirement funds, while 401(k)s are employee-sponsored plans. Both IRAs and 401(k)s are available as Traditional or Roth accounts, the primary difference being when contributions and withdrawals are taxed. It’s possible to contribute to both an IRA and 401(k) if both are available to you, and you can roll over funds from one plan to another, penalty-free – as long as IRS guidelines are followed.

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