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401(k) vs. IRA: Which is best for you?

401(k)s and IRAs both offer valuable tax benefits for retirement savers, but they differ in how they help you get there.

Both 401(k)s and IRAs are types of retirement accounts, each with its own benefits and drawbacks. Whether one is better suited for you ultimately depends on your goals and circumstances.

401(k) vs. IRA: What’s the difference?

Despite both providing valuable tax benefits for retirement savings, 401(k)s and IRAs differ in some key ways. The main difference is that employers offer 401(k)s, whereas IRAs are opened by individuals.

IRAs offer retirement savers a greater selection of investments to choose from compared to their 401(k) counterparts, but savers can’t contribute nearly as much to an IRA as they can to a 401(k).

But 401(k)s stand out for one main reason: Employers will often match contributions made by employees. So if you’re trying to decide which retirement account is best for you, first consider if your employer offers a company match. If it does match some of your contributions with its own cash, not participating in your company’s 401(k) means you’re leaving money on the table.

If you want the greater flexibility an IRA can offer, at least contribute enough to the 401(k) first to get the company match.

401(k)s and IRAs compared

401(k)s and IRAs come in several varieties, and different rules apply to each. Here are the basics for how 401(k)s and IRAs compare:

401(k)IRA
Plan typeQualified retirement planIndividual retirement plan
Offered byEmployerSet up an IRA with a:
  • Bank or other financial institution
  • Life insurance company
  • Mutual fund
  • Stockbroker
2022 contribution limits$20,500$6,000 ($7,000 if you’re 50 or older)
Early withdrawal penaltyIncluded in gross income plus a 10% additional penaltyIncluded in gross income plus a 10% additional penalty
Contribution typeFour main types of 401(k) contributions:
  1. Salary reduction/elective deferral
  2. Designated Roth contributions
  3. After-tax contributions
  4. Catch-up contributions
Two main types of IRA contributions:
  1. Pre-tax (Traditional)
  2. After-tax (Roth)
Tax benefitsTraditional 401(k)
  • Employee contributions and any earnings are tax-deferred

Roth 401(k)

  • Interest, dividends or capital gains income earned on the account are tax-free
Traditional IRA
  • Contributions to a traditional IRA are typically tax-deductible

Roth IRA

  • Earnings and withdrawals are tax-free

How does a 401(k) work?

A 401(k) is a qualified retirement plan offered by employers that qualifies for tax breaks under the Internal Revenue Code (IRC). These plans provide employees with a choice of investment options, but index funds and mutual funds are the most common options. Since these are professionally managed investments, you’ll have to pay a small fee.

There are two types of 401(k) accounts –– traditional 401(k)s and Roth 401(k)s. It’s possible to split your contributions between both, but the maximum you can contribute is $20,500 for 2022.

Traditional 401(k)

In a traditional 401(k), employee contributions are made through payroll deductions using pretax dollars. While you don’t take a tax deduction for your 401(k) contributions when it comes time to file your taxes, those pretax contributions can reduce your overall tax liability at the end of the year.

Any earnings from the investments in a 401(k) are also tax-deferred. That means you pay taxes on contributions and earnings when you withdraw money at retirement.

Begin withdrawing money from your 401(k) once you reach age 59 ½. If you take a distribution any earlier, you may incur a 10% penalty.

Roth 401(k)

A Roth 401(k) is similar to a traditional 401(k), but employee contributions are not tax-deferred and are made with after-tax dollars. Since contributions are made with money you’ve already paid taxes on, contributions and earnings withdrawals are not taxed when you begin taking distributions at retirement.

As a benefit to employees, some employers will contribute money to employees’ 401(k)s, make matching contributions based on employees’ elective deferrals, or both. Taxes on employer contributions are also tax-deferred until savings are withdrawn.

Pros and cons of 401(k)s

Pros

  • Many employers offer matching contributions
  • High annual contribution limit
  • Tax advantages

Cons

  • Limited investment options
  • Higher account fees
  • Early withdrawal penalties

How does an IRA work?

An IRA is a tax-advantaged account individuals can use to save for retirement. There are several types of IRAs, but the two most common types are traditional and Roth. Like a 401(k), you can split your contributions between both. But your contributions are limited to $6,000 in total.

Traditional IRA

Contributions made to a traditional IRA are typically tax-deductible. You don’t pay any taxes on your earnings until you begin taking distributions at retirement, at which point your withdrawals are taxed as income.

Roth IRA

Contributions made to a Roth IRA, on the other hand, are made with after-tax dollars. So Roth IRA contributions are not tax-deductible.

So earnings and withdrawals are tax-free. In other words, since you paid taxes before making contributions, you aren’t taxed when you take distributions in retirement.

Similar to an individual brokerage account, funds contributed to both traditional and Roth IRAs can be invested in a wide range of assets, including:

  • Stocks
  • Bonds
  • US Treasuries
  • CDs
  • Mutual funds
  • ETFs
  • Annuities

Whereas 401(k)s often limit you to a narrow selection of investments, IRAs allow you to take full control over how your money is invested. But like 401(k)s, you aren’t afforded this same level of control when it comes to withdrawing your money.

IRAs are designed with retirement in mind. And although you can take a distribution at any time, withdrawals prior to age 59 ½ are generally subject to a 10% early withdrawal penalty plus applicable taxes. But since Roth IRA contributions are made with after-tax dollars, you can withdraw your contributions any time, tax-free. Only earnings are subject to income tax.

Pros and cons of IRAs

Pros

  • Tax-free growth
  • Tax deductions for contributions made to traditional IRAs
  • Anyone can contribute

Cons

  • $6,000 total contribution limit
  • Early withdrawal penalties
  • Required minimum distributions for traditional IRAs when you reach 72

Contribution limits

There are limits on how much you can contribute to a retirement plan each year, and the limits differ depending on the type of plan.

401(k) contribution limits

For 2022, your individual contribution limit is $20,500. Those 50 or older are allowed to contribute an additional catch-up contribution of $6,500.

IRA contribution limits

For 2022, your individual contribution limit is $6,000, or $7,000 if you’re 50 or older. This is the total combined contribution you make to all of your traditional IRAs and Roth IRAs. Since IRAs are individual retirement accounts, married couples can each contribute to their own separate IRAs.

Compare retirement accounts

Name Product Annual fee Available asset types
The IRA Club
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Open a self-directed IRA and begin investing with true flexibility.
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Disclaimer: The value of any investment can go up or down depending on news, trends and market conditions. We are not investment advisers, so do your own due diligence to understand the risks before you invest.

Bottom line

Both 401(k)s and IRAs offer valuable tax benefits for retirement savers. If your employer offers a company match, consider contributing enough to take advantage of that free money. After you’ve gotten the match, max out your IRA for the year, returning to the 401(k) until you reach its higher $19,500 contribution limit. In any case, the sooner you start investing, the better.

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