IRA vs. 401(k): Which one is better?

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Americans have several choices when it comes to saving for retirement, and two of the most popular options are a 401(k) plan and an individual retirement account (IRA). Assets in 401(k) plans totaled $6.7 trillion as of year-end 2020, according to the Investment Company Institute (ICI). Meanwhile, IRAs had a massive $12.2 trillion balance in the same period, says ICI.

Many people get the two plans confused, and it’s understandable, given the similarities between them. Both offer the potential for tax-deferred investment growth (or tax-free growth if you opt for the Roth versions of either plan), tax breaks on contributions and the ability to invest in assets such as stocks and mutual funds that have a higher potential return than savings accounts and bonds.

With so many similarities, which one should investors choose? Well, if you can max out your contributions to both, then you won’t have to choose — while enjoying the full advantages each has to offer. But even though it’s permitted, many people can’t afford to do so.

Forced to choose, many experts believe the 401(k) is the clearly superior option.

“There is actually no comparing IRAs and 401(k)s,” says Joseph Auday, wealth advisor with Steel Peak Wealth Management in Beverly Hills, California, citing the 401(k)’s higher contribution limit and the potential for an employer match. “If you’re not taking advantage of your 401(k), you’re missing out.”

However, other advisers also stress that both plans remain valuable to retirement planning.

“IRAs and 401(k)s can both provide unique value to an individual’s retirement strategy, with key uses and specific pros and cons worthy of consideration,” says Michael Burke, CFP at Lido Advisors in Southbury, Connecticut.

Below are nine key ways in which a 401(k) and an IRA differ.  We’ll also discuss which one may be a better fit for your personal retirement situation.

1. IRAs are easier to obtain

While the IRA and 401(k) share many similarities, the IRA is easier to obtain. If you have earned income in a given year, then you can contribute to an IRA. (And even spouses of workers can set one up without earned income.) You can set them up at many financial institutions, including banks and online brokerages. And if you open an IRA online, you can do it in 15 minutes or less.

That’s not the case with a 401(k) plan, which is created and sponsored by your employer. If your employer doesn’t offer the plan, then you simply won’t have the option, though you’ll still have the possibility to open an IRA.

In addition, an employer may have a waiting period for its 401(k) plan. “New employees may have to wait a period to join – up to six months or a year in some cases,” says Burke.

That’s not the case for IRAs, which can be opened at any time.

2. 401(k) plans may offer an employer match

While they might be harder to obtain, 401(k) plans make up for it with the potential for free money. That is, many employers will match your contributions up to some level.

“401(k)s sometimes will have a match depending on the employer’s generosity and financial position,” says Michael Lackwood, founding principal of New York City-based Spring Delta Asset Management. “If your employer does offer a match, it makes most sense to contribute to the 401(k) at least up to the maximum percentage match.”

For example, if you contribute 4 percent of your salary, your employer may offer 2, 3 or 4 percent, as an inducement to help you save. That’s free money and an immediate return on your investment.

In contrast, you’re on your own with an IRA, and your funds will consist only of what you contribute and any earnings on those contributions.

3. IRAs offer a better investment selection

If you want the best possible selection of investments, then an IRA – especially at an online brokerage – will offer you the most options. You’ll have the full suite of assets on offer at the institution: stocks, bonds, CDs, mutual funds, ETFs and more.

“Generally, for investment selection and overall management of your funds, I would say IRAs have a clear advantage,” says Lackwood.

In contrast, 401(k) plans usually offer only a relatively small selection of investments, even if it does offer the key fundamental types, such as a money market fund and a Standard & Poor’s 500 index fund.

“Usually, employers restrict the 401(k) the choice of investments to 15-20 positions whereas an IRA allows thousands of different choices,” says Lackwood.

“IRAs tend to allow significantly more investment options than the average 401(k) plan does and can therefore be better tailored to each individual,” says Burke.

4. IRAs require some investment knowledge

The flip side of having many investment choices in an IRA is that you have to know what to invest in, and many participants simply aren’t in a position to do that. And that’s where a 401(k) may offer a better option for workers, even if the investment selection is more limited.

A 401(k) is “often turnkey,” says Claire Toth, senior wealth strategist at Peapack-Gladstone Bank in Summit, New Jersey. “Set it and forget it.”

So while a 401(k) may offer fewer choices, says Toth, they do provide “okay default investment options for participants without knowledge” and they may offer coaching to help participants understand their choices.

Still, if you do have that knowledge already, Lackwood says, you can “manage your IRA how you see fit with quick attention (if necessary) and with possibly less administrative cost.”

5. 401(k)s offer higher contribution limits

In this category, the 401(k) is simply objectively better. The employer-sponsored plan allows you to add much more to your retirement savings than an IRA.

For 2021, a 401(k) plan allows you to contribute up to $19,500. Participants age 50 and older can add an additional $6,500, for a total of $26,000.

In contrast, an IRA limits contributions to $6,000 for 2021. Participants age 50 and older can add an additional $1,000, for a total of $7,000.

That’s a clear advantage for the 401(k).

6. 401(k) contributions are always tax-deductible

Another key advantage for the traditional 401(k) is that contributions are always tax-deductible, regardless of your income. If you add to your 401(k), you make those contributions with pre-tax money.

“Any pre-tax contributions will lower an individual’s tax amount for the year,” says Burke. “There is no phase-out at any level of income.”

In contrast, contributions to an IRA may or may not be tax-deductible, depending on your income and whether you’re already covered by a 401(k) plan at work. The deductibility of contributions phases out as your income increases.

7. It’s easier to set up a Roth with an IRA

Both the 401(k) and the IRA have a variation called a Roth, which provides special tax advantages. The key advantage of either Roth account is that participants will not have to pay any tax on withdrawals at retirement. In exchange, their contributions are made with after-tax money, so they don’t receive a tax break on today’s taxes as they do with traditional plans.

However, not all employers offered a Roth 401(k) – just 75 percent in 2019. If your company doesn’t offer the Roth version, you don’t have that alternative.

But anyone who can open an IRA can open the Roth variant. While the Roth IRA technically has an income limit that prevents participants from opening it, there’s a legal way to do so anyway called a “backdoor Roth IRA.” Here are the details on the backdoor Roth.

8. You can take a loan on a 401(k)

Generally if you take out cash from an IRA or a 401(k), you’ll likely be charged taxes and penalties. But the 401(k) may allow you to take out a loan, depending on how your employer’s plan is structured.

“Another clear advantage is that you can take loans from a 401(k) and continue to contribute to your 401(k),” says Lackwood.

Like a normal loan, you’ll have to pay interest, and you’ll have a repayment period, not more than five years. But the rules differ from plan to plan, says Lackwood, so you’ll have to check on your specific 401(k) rules to see what you’ll need to do.

You can also take cash from a 401(k) for a hardship withdrawal, and you can do so from an IRA, too. But the terms in each case are strict.

“401(k)s allow for emergency withdrawals, but most plans offered through employers are very rigid and don’t have much flexibility,” says David Wilson, CFP and founder of Planning to Wealth.

But taking a non-retirement withdrawal can drastically set back your retirement plans.

9. A 401(k) is more secure from creditors

What happens to your retirement money in the event of a bankruptcy or an adverse lawsuit? The 401(k) is more secure from creditors than the IRA.

“The real advantage of a 401(k) is that in most states the 401(k) is protected from creditors and lawsuits, except for the IRS and a spouse,” says Lackwood. “Otherwise, the individual is protected and should keep funds in a 401(k) until the lawsuit or any concerns are removed.”

Individuals can roll over a 401(k) into an IRA when they leave an employer, but many may choose not to do so, because of the relative lack of security in an IRA, says Lackwood.

What are the pros and cons of a 401k?

To sum up, the 401(k) plan offers a variety of pros and cons. Here are the most important:

Pros of a 401(k)

  • Higher contribution limit
  • Potential for “free money” via a company match
  • No income limit on contributing with pre-tax income
  • May be able to access a loan
  • More secure against creditors
  • Automatic payroll deductions
  • May have investment guidance from plan administrator

Cons of a 401(k)

  • No guarantee that your employer offers one
  • Limited investment selection
  • May not be possible to set up a Roth version

What are the pros and cons of an IRA?

The IRA offers a similar variety of pros and cons. Here are the most important:

Pros of an IRA

  • Available to anyone with earned income
  • Non-earning spouses can contribute, too
  • Wide array of investment options
  • Easy to set up traditional or Roth versions
  • Roth IRA is great for estate planning
  • Roth IRA offers tremendous flexibility, including penalty-free withdrawals of contributions

Cons of an IRA

  • Relatively low contribution limits
  • Deductibility of contributions is limited due to income
  • No investment advice

Bottom line

“The best retirement plan for an individual will often include both a 401(k) as well as an IRA,” says Burke. “By understanding the differences between the two, an individual can make better informed decisions, and ensure they are getting the most value out of their investment choices.”

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Written by
James Royal
Senior investing and wealth management reporter
Bankrate senior reporter James F. Royal, Ph.D., covers investing and wealth management. His work has been cited by CNBC, the Washington Post, The New York Times and more.
Edited by
Senior wealth editor
Reviewed by
Professor of finance, Creighton University