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IRA vs 401(k) – What’s the Difference?

Key facts

  • Two of the most popular choices for retirement saving are IRAs and 401(k)s.
  • Employers must set up a 401(k) plan while an IRA can be managed by the individual investor.
  • Assess your employer offerings and your own financial situation to determine which retirement plan is best for you.

IRA vs 401(k): Which is Better for You?

What is an IRA?

An IRA is an individual retirement arrangement where individuals receive tax benefits for contributing, depending on the type of plan selected. All IRAs typically have restrictions on when you may contribute, how much you may contribute, and how distributions are made. The most common types are Traditional IRAs and Roth IRAs, but you can also use a SEP IRA, a Self-Directed IRA, or a SIMPLE IRA.

What is a 401(k)?

A 401(k) is an employer-sponsored tax-deferred retirement account. Both employees and employers may contribute to the plan. Most people select either a Traditional 401(k) or a Roth 401(k), depending on what’s made available by their employer. Like the IRA counterparts, the key difference between these two plans is in how contributions and withdrawals are taxed.

IRA and 401(k) plan comparison

Traditional 401(k) Roth 401(k) Traditional IRA Roth IRA
Eligibility Offered through employer Offered through employer No income limit Income limit applies
Annual Contribution Limits $18,000 $18,000 $5,500 (under age 50), $6,500 (age 50 or older) $5,500 (under age 50), $6,500 (age 50 or older)
Withdrawal Rules 10% penalty on early withdrawals Contribution amounts may be withdrawn penalty-free 10% penalty on early withdrawals Contribution amounts may be withdrawn penalty-free
Minimum required distribution at age 70 1/2 No minimum required distributions Minimum required distribution at age 70 1/2 No minimum required distribution
Employer contributions may not vest immediately Early withdrawal of earnings allowed for qualifying events
What You Can Invest In Employers limit investment options Employers limit investment options IRS restrict investing in life insurance or collectibles; the investment manager you choose may also limit asset choices IRS restrict investing in life insurance or collectibles; the investment manager you choose may also limit asset choices
Tax Benefits Contributions are made with pre-tax funds but distributions are taxable Contributions are made with after-tax funds but distributions are taxed exempt Contributions are tax-deductible but distributions are taxable Contributions are not tax deductible but distributions are tax exempt
May be eligible for Saver’s Credit May be eligible for Saver’s Credit May be eligible for Saver’s Credit May be eligible for Saver’s Credit

Which Account is Right for You

The main difference between a 401(k) and an IRA is that the former is offered through an employer and the latter is initiated by an individual or small business. If your employer offers a 401(k), there are several reasons to take advantage of it. Employers often offer matched contributions, which is another form of compensation. In addition, the 401(k) annual contribution limits are much higher at $18,000 when compared to $5,500 (or $6,500 for age 59 ½ or older) for IRA.

However, if your employer has a strict vesting schedule and you don’t plan on staying there long-term, it may still make sense to look beyond 401(k). An IRA may also make sense for employees who don’t receive any type of matched contributions or don’t have access to a workplace retirement account at all.

A Roth IRA, in particular, may be more attractive to younger professionals since contributions are taxed at a time when their tax brackets are lower and distributions can be made tax-free at a time when they are likely in a higher tax bracket. On the flip side, if you’re earning a substantial income already, you may benefit more from getting the tax deduction now through a Traditional IRA. The same guidance applies to employees debating between a Traditional 401(k) and a Roth 401(k).

Can You Have Both?

Yes, you can have both a 401(k) and an IRA, although certain limitations apply. If you open a Traditional IRA in addition to your 401(k), your ability to claim tax deductions on contributions to your IRA phases out depending on your income level. For a Roth IRA, you may make contributions along with your 401(k) as long as you meet the Roth IRA income requirements.


Disclosure

Nothing in this article should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. This article is not intended as investment advice, and Wealthfront does not represent in any manner that the circumstances described herein will result in any particular outcome. Financial advisory services are only provided to investors who become Wealthfront clients.

This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Investors and their personal tax advisors are responsible for how the transactions in an account are reported to the IRS or any other taxing authority.

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