Key Takeaways

  1. 401(k)s and IRAs are two types of investment accounts designed for retirement.
  2. A 401(k) is a company-sponsored retirement plan that has two types: Traditional 401(k) and Roth 401(k).
  3. Individual Retirement Accounts (IRAs) are set up and controlled by individuals. 
  4. There are five factors where these retirement accounts differ: eligibility, contribution limits, investment options, taxes & withdrawal periods and portability.
  5. Investors can have both an IRA and a 401(k), but there may be contribution limits and tax considerations.

Many of us, no matter our ages, are saving for retirement. While there are many ways to save and invest for it, there are investment accounts that offer significant tax benefits designed specifically to help you build wealth for retirement: the 401(k) and the IRA.

Each account type has a unique set of rules and regulations regarding how to contribute, how much you can contribute, how savings are taxed, and more. 

So which account is right for you? The answer depends on your personal situation and the right choice can, and likely will, change over time as your life, career, and finances evolve. Here’s what you need to know about 401(k)s and IRAs and what to consider when determining which one is right for you.

What is a 401(k)?

A 401(k), named after a section of the IRS tax code, is a company-sponsored retirement plan that allows eligible employees to contribute a portion of their salary (called a deferral), invest their savings for their future, and receive tax benefits along the way. 

To further incentivize employees to contribute, many employers make what is called a matching contribution, which means that when you put money into your account your employer adds some as well. They typically match your contributions up to a certain percentage of your pay, say 3%. How employer matching contributions are determined can vary, so check with your employer. 

What are the Different Types of 401(k)s?

Traditional 401(k): Employees contribute a portion of their salary to their company retirement plan. They do not pay income taxes on the amount they contribute in the same year (called before- or pre-tax contributions), nor do they pay taxes as the money grows. Taxes are due when money is taken out of the account, also called a withdrawal or distribution. You only pay taxes on the amount distributed.

Roth 401(k): Employees contribute a portion of their salary after paying taxes on the income (called post-tax contributions). The account grows tax-deferred, and, when the money is taken out, the distributions (assuming they meet certain guidelines) are not taxable. Roth provisions are not required to be offered even if your company has a 401(k) plan, so you may not have the option to make Roth contributions to your company’s retirement plan.

Important note: There are no income limits for contributing to either plan (unlike Roth IRAs and IRAs in some cases). Depending on your employer, there may be an income limit for matching contributions.

What is an IRA? 

An individual retirement account, or IRA, is an investment account designed to allow individuals to save and invest for their retirement that comes with many tax advantages. Unlike 401(k) accounts, which are set up by an employer, Individual Retirement Accounts (IRAs) are set up by individuals. As with 401(k)s, there are two types.

What are the Different Types of IRAs?

Traditional IRAs: Individuals make contributions with money that they might be able to deduct from their taxable income (i.e. they won’t pay taxes on the money today). The money grows tax-free and withdrawals are taxable as ordinary income.

Roth IRAs: Individuals make contributions with money that has already been taxed (i.e. after-tax contributions). The money in the Roth IRA grows without paying taxes (tax-deferred), and any distributions in retirement are tax-free (if withdrawal requirements are met). If your income is above a certain limit, you are not allowed to make Roth IRA contributions.

What are the Key Differences Between an IRA and 401(k)? 

There are five factors where these retirement accounts differ:

  1. Eligibility
  2. Contributions
  3. Investment Options
  4. Taxes & Withdrawal
  5. Portability

401(k)

Traditional IRA

Roth IRA

Eligibility
Eligibility
Traditional 401(k): Must work for an employer that offers a 401(k).

Roth 401(k): Must work for an employer that offers a 401(k) that allows Roth contributions.
Anyone with earned income can open and contribute to an IRA.
Anyone with earned income below a specified limit can open and contribute to an IRA.
Contributions
Contributions
Traditional 401(k): Deducted from the employees’ paycheck (pre-tax).

Roth 401(k): Deducted from the employees’ paycheck (post-tax).

Can make contributions at any income level (unlike Roth IRA contributions).

Both: Employers may match a portion of contributions.

Employees under 50 can contribute up to $20,500 per year; employees over 50 can make additional catch-up contributions up to $6,500 for a total of $27,000.
Individual account owner makes contributions.

If under 50, can contribute up to $6,000 per year; over 50 can make additional catch-up contributions up to $1,000 for a total of $7,000.

Tax deductions depend on income and whether you or your spouse contribute to a company retirement plan, such as a 401(k).

Can make non-deductible IRA contributions regardless of 401(k) participation and income.
Individual account owner makes contributions.

If under 50, can contribute up to $6,000 per year; over 50 can make additional catch-up contributions up to $1,000 for a total of $7,000.

Contributions do not depend on eligibility for a 401(k) but may be limited based on income.
Investment Options
Investment Options
Both: Typically limited to a short list of mutual funds offered by the plan.

Some plans offer broader investment options.

Employer controls plan costs and fees.

Account owner chooses where to set up the account and has access to a wide variety of investments.

Individuals can set up an account through any broker or financial institution that offers IRAs.

Account owner chooses where to set up the account and has access to a wide variety of investments.

Individuals can set up an account through any broker or financial institution that offers IRAs.

Taxes & Withdrawals
Taxes & Withdrawals
Traditional 401(k): Distributions are taxable as ordinary income; no penalties after age 59 ½.

Roth 401(k): Distributions after age 59 ½ are penalty free.

Roth contributions, and growth, are tax free. Employer contributions are taxable.

Both: If the plan allows it, loans can be taken out against a 401(k).
Distributions and growth are taxed as ordinary income in most cases.

Distributions after age 59 ½ are penalty free.

Loans are not available.

Required minimum distributions (RMDs) after age 72 (previously age 70 ½).

No income taxes on growth if the Roth IRA has been open five years and the account owner is over age 59 ½.

Can withdraw contributions without penalty or taxes at any time.

No required minimum distributions (RMDs).
Portability
Portability
Both: Cannot contribute after leaving employer.

Account can be transferred (rollover) to a new 401(k) or IRA.
IRA owner has full control over where the account is held and can determine the broker or financial institution.

IRA to IRA transfers are not taxable.
Roth IRA owner has full control over where the account is held and can determine the broker or financial institution.

Roth IRA to Roth IRA transfers are not taxable.

Withdrawal Considerations

401(k) Withdrawal Considerations:

  • Taxes: Because 401(k)s are designed to be long-term retirement savings vehicles, withdrawals before age 59 ½ will be assessed a 10% penalty. There are exceptions to this rule, but you will always pay income taxes on any pre-tax money.
  • Withdrawal Exceptions: Some plans allow penalty-free withdrawals at age 55 if the employee leaves work, which is called the Rule of 55. Check with your employer.
  • Loans: Most plans allow for loans, limited to the lesser of $50,000 or 50% of the vested account balance. Terms vary from plan to plan, but loans must be repaid, with interest, within five years, or immediately when leaving the employer (or be subject to taxes and penalties).

IRA Withdrawal Considerations:

  • Traditional IRAs: Withdrawals prior to age 59 ½ are subject to taxes and, in most cases, a 10% penalty. Loans are not allowed. After age 72, must take a minimum distribution from the account (aka an RMD).
  • Roth IRAs: Withdrawals of contributions may be made at any time without taxes or penalties. Earnings are tax-free if they are withdrawn after reaching age 59 ½ and if the account has been open for five years. Rules vary based on whether the funds were a direct contribution or a conversion from a traditional IRA.

Can You Have a 401(k) and an IRA?

Yes, investors may have both. However, in some cases investors cannot contribute to both accounts in the same year and receive a tax deduction.

For example, if you contribute to a 401(k), there are income limits for making a deductible IRA contribution. That being said, you can still make an IRA contribution to continue to build your retirement fund, it just won’t be tax deductible.

Roth IRA contributions are completely independent of your 401(k) contributions and are based solely on your income and tax filing status. Said differently, if you are eligible to contribute to a Roth IRA (i.e. your income falls within the allowable limits), you can contribute to both a 401(k) and a Roth IRA in any given year. 

How to Max Out Your 401(k) and IRA 

  • A 401(k) with an employer match is always the best first step. The employer match is essentially free money.
  • IRAs and Roth IRAs generally offer a broader selection of investment options but Roth IRAs are subject to income limits so you may not be eligible. A 401(k) has higher contribution limits.
  • For some high-income earners, using a backdoor Roth IRA while maximizing contributions to a 401(k) can be a great strategy, but you must be familiar with the process and the IRA pro-rata rule to avoid a surprise tax bill.

Which Retirement Account is Right for You?

Both a 401(k) and IRA can be great retirement vehicles and should be used in combination to maximize retirement savings. The account you choose, the type of contributions (pre- vs. post-tax), and how much to save will depend on your situation today and your plans for your future.

You may also want to consider taxable investment accounts where appropriate to further diversify taxes. For maximum flexibility, investors should have three primary taxable buckets of money: pre-tax, post-tax (Roth), and taxable (taxable investment account).

Your strategy needs to be dynamic as your life evolves personally, professionally, and financially, to ensure you maximize your retirement savings and reduce your taxes today, as your money grows, and when you need it in the future.

To learn how a CFP® Professional can help you create a strategy to maximize your retirement savings and reduce your tax liability today and in the future, schedule a free, introductory call today.