401(k) vs. IRA: An Overview
You might find yourself choosing between a 401(k)—maybe your employer offers one—and an individual retirement account (IRA), which anyone can open. If so, you're not alone—though you can have both.
These accounts can be key in setting you up for a solid retirement, but they are different. Read on to learn how, exactly.
Key Takeaways
- 401(k) plans and IRAs are retirement savings accounts that hold assets that, in most cases, cannot be accessed without penalty until the owner is age 59 ½.
- Employers offer 401(k)s and some IRAs and may match an employee’s contributions.
- Individuals can set up a traditional IRA or Roth IRA through a financial institution.
Saving With a 401(k)
A 401(k) is a defined-contribution plan offered by many employers. You contribute a percentage of your salary to your 401(k), and your employer may match contributions up to a specific limit. Investment vehicles commonly include mutual funds selected by the sponsor. The fund choices are designed to meet a specific risk tolerance for employees, often in a target date fund that anticipates a specific retirement year. A loan may be an option.
Total contributions—by both employee and employer—to a 401(k) may not exceed $69,000 (or $76,500 for investors age 50 or older) in tax year 2024 (up from $66,000 and $73,500, respectively. in 2023). The total contribution to a 401(k) also cannot exceed 100% of the participant's compensation.
For traditional 401(k) accounts, your contributions are made pretax, meaning your contributions reduce your taxable income for that year by the contribution amount. For example, if you have a $50,000 salary and contributed $10,000 to a 401(k), then your taxable income for the year would be $40,000.
Roth 401(k)s work a bit differently. Unlike a traditional 401(k), Roth contributions are funded with after-tax money and do not reduce your taxable income for the year. Although there's no upfront tax break, withdrawals in retirement are tax- and penalty-free, under two conditions. (You must be at least 59 ½ years old, and you must have had the account for at least five years.)
With a traditional account, withdrawals are taxed at your income tax rate. Like with a Roth account, there’s no penalty for withdrawals as long as the distributions are made at age 59 ½ or older.
The exception to the age requirement (59 ½) are qualified withdrawals: that is, hardship withdrawals. Those are penalty-free.
Make sure to review your 401(k) retirement plan documents to determine if there’s an employer match, and if so, what the maximum match and the minimum employee contribution are to qualify for a matching contribution.
Saving With an IRA
An IRA is typically held by a brokerage or investment firm. In general, it offers more investment options than a 401(k), but contribution limits are much lower. For tax year 2024, you can't contribute more than $7,000 to an IRA unless you're age 50 or older (up from $6,500 in 2023). In that case, you can contribute an additional $1,000. And since most IRAs aren't sponsored by an employer, there's no matching contributions.
There are two exceptions: Savings Incentive Match Plan for Employees (SIMPLE) IRAs and simplified employee pension (SEP) IRAs. These IRAs are sometimes offered by companies with 100 or fewer employees. They have fewer administrative burdens than 401(k) plans. Self-employed people, who essentially act as both employer and employee, may be eligible.
SEP IRAs: SEP IRAs have higher annual contribution limits than standard IRAs, and only an employer (or self-employed person) can contribute. Employer contributions can be as much as 25% of an employee’s gross annual salary. The annual contribution limit is $69,000 or $76,500 for those 50 or older for tax year 2024 (up from $66,000 or $73,500 in 2023).
SIMPLE IRAs: SIMPLE IRA contributions work differently. An employer can match up to 3% of an employee’s annual contribution or set up a nonelective 2% contribution of each employee’s salary. The latter doesn’t require employee contributions. The contribution limit for employees is $16,000 in 2024 ($15,500 in 2023), with an additional catch-up contribution of up to $3,500 for people age 50 or older in 2023 and 2024.
Like traditional 401(k)s, traditional IRAs are tax-deferred until the funds are withdrawn. Contributions to a Roth IRA, on the other hand, work just like a Roth 401(k): they're made with after-tax dollars. You don’t receive a tax break in the year of the contribution, but qualified distributions are tax-free in retirement.
The age requirement is the same as with 401(k) plans: withdrawals are penalty-free after the IRA holder turns 59½. Withdrawals before that incur a 10% tax penalty unless the withdrawal qualifies as a hardship withdrawal.
Unlike 401(k) plans, the IRS does not allow individuals to borrow against the balance of their IRA.
Key Differences
The primary differences between 401(k) plans and IRAs are explained in the following table.
| 401(k)s vs. IRAs: 2023 Limits and Policies | ||
|---|---|---|
| 401(k) Plan | Individual Retirement Account | |
| Annual Contribution Limits (if younger than 50) | $22,500 | $6,500 |
| Catch-Up Contribution Limits (if older than 50) | $7,500 (for total of $30,000) | $1,000 (for total of $7,500) |
| Contribution Source | Contributions automatically deducted from paycheck. Employer may match contributions. | Account owners must fund their own accounts. |
| Choice of Assets | A few funds chosen by the plan administrator | A much wider selection of stocks, mutual funds, index funds, and other assets |
| Creation | Set up by employers | Set up by account holders |
| Types of Accounts | Roth and traditional 401(k) | Traditional, Roth, SEP, and SIMPLE IRAs |
| Required Minimum Distributions | Start in the year you reach 73 or 75 depending on the year you were born. | Start in the year you reach 73 or 75 depending on the year you were born. (Roth IRAs are not subject to required minimum distributions.) |
| 401(k)s vs. IRAs: 2024 Limits and Policies | ||
|---|---|---|
| 401(k) Plan | Individual Retirement Account | |
| Annual Contribution Limits (if younger than 50) | $23,000 | $7,000 |
| Catch-Up Contribution Limits (if older than 50) | $7,500 (for total of $30,500) | $1,000 (for total of $8,000) |
| Contribution Source | Contributions automatically deducted from paycheck. Employer may match contributions. | Account owners must fund their own accounts. |
| Choice of Assets | A few funds chosen by the plan administrator | A much wider selection of stocks, mutual funds, index funds, and other assets |
| Creation | Set up by employers | Set up by account holders |
| Types of Accounts | Roth and traditional 401(k) | Traditional, Roth, SEP, and SIMPLE IRAs |
| Required Minimum Distributions | Start in the year you reach 73 or 75 depending on the year you were born. | Start in the year you reach 73 or 75 depending on the year you were born. (Roth IRAs are not subject to required minimum distributions.) |
How Much Do Employers Match?
Employers typically match a percentage of their employee's contributions up to a certain limit or percentage. An employer might match based on how much the employee contributes annually. For example, an employer could match 50% of an employee’s contribution up to 6% of their salary. The average 401(k) is 4.6%, while the median match is 4.0%, according to Vanguard.
Is a 401(k) Considered an IRA for Tax Purposes?
Not all retirement accounts have the same tax treatment. There are different tax benefits for IRAs and 401(k)s. Roth IRAs don’t offer a tax break for contributions, but qualified withdrawals are tax-free in retirement, as long as you've had the account for five years and are older than 59 ½. Traditional IRAs offer a tax break. Traditional 401(k)s allow pre-tax income to be deposited, which reduces taxable income in the year of the contribution. Distributions from traditional 401(k)s and IRAs are considered taxable income.
Can You Lose Money in an IRA?
Yes. IRA money held by a brokerage or investment firm is usually invested in securities such as mutual funds or stocks, which fluctuate in value. Note that an IRA is no more or less likely to decline in value than any other investment account. The owner of an IRA faces the same market risks as a 401(k).
Can You Roll a 401(k) Into an IRA Penalty-Free?
The IRS allows for a rollover or transfer of your funds from a 401(k) to an IRA. However, the process and guidelines outlined by the IRS must be followed so that the IRA transfer doesn’t count as a distribution, which could incur a 10% tax penalty if you're younger than 59 ½. The easiest way to ensure funds roll over penalty-free is with a direct rollover.
The Bottom Line
IRAs and 401(k)s are investing tools with different strengths and weaknesses. Though there's no reason to choose—you can have both, and actually, you can have multiples of each—it's worth considering what each offers before depositing funds. That said, you can transfer between accounts, most easily with a direct rollover.
