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

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Americans have several choices when it comes to saving for retirement. 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. 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.

Below are the 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.

What is an IRA?

An IRA is an individual retirement account that allows anyone with earned income (and even their spouses) to save for retirement on a tax-advantaged basis. Inside an IRA your money can grow tax-free or tax-deferred until you take it out at retirement. This special tax advantage allows your money to compound at a higher rate, letting you accumulate more over time.

The annual contribution limit to an IRA is $6,000 in 2022, though this figure usually rises every few years. Those over age 50 can contribute an additional $1,000 each year.

You can open an IRA at many different financial institutions, including banks and brokers, and you can buy several kinds of assets inside your IRA, including CDs, stocks, bonds, mutual funds, ETFs and more. The best IRA accounts let you invest in potentially high-return assets such as stocks and stock funds.

Types of IRAs

There are two major types of IRAs, and they differ in the tax advantages they offer you:

  • The traditional IRA can allow you to save for retirement on a pre-tax basis, meaning that you won’t pay taxes on any contributions you make to the account. The money inside the account can grow tax-deferred until you take it out in retirement, defined as age 59 ½ or later. When you withdraw the money, you’ll pay taxes at ordinary income rates. After age 72, you’ll be forced to take required minimum distributions each year. The tax deductibility of a traditional IRA depends on your income as well as whether your employer offers a retirement plan.
  • The Roth IRA allows you to save for retirement using after-tax money, meaning you won’t enjoy a tax break on contributions. However, you will be able to grow your money tax-free and then withdraw it tax-free in retirement, defined as age 59 ½ or later. Unlike the traditional IRA, you won’t be forced to take minimum withdrawals, and you can even pass the money down to your heirs tax-free. The Roth IRA has income restrictions, so if you make too much, you might not be able to take advantage of it.

Those are some of the largest differences between the two major types of IRA, but you’ll want to understand some of the other finer points on each IRA before deciding which is right for you.

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
  • A Roth IRA is great for estate planning
  • A Roth IRA offers 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

What is a 401(k)?

A 401(k) plan is an employer-sponsored retirement plan that allows a company’s workers to save for retirement on a tax-advantaged basis. In a 401(k), money can grow tax-deferred or tax-free until withdrawn at retirement. Employees can deduct a portion of their salary from their paycheck and have it invested in potentially high-returning assets such as stock mutual funds.

The annual contribution limit to a 401(k) is $20,500 in 2022, and this figure usually rises every few years. Those aged 50 and over can make a $6,500 catch-up contribution each year.

You may only open a 401(k) plan if your employer offers one. The plan will provide a fixed set of investments, often mutual funds, that you may invest in. These funds typically invest in stocks, bonds or a combination of the two such as in target-date funds.

Many 401(k) plans also “match” a portion of the employee’s contributions to the account, providing “free money.”  An extra three to five percent of salary (sometimes more) is possible.

Types of 401(k) plans

There are two major kinds of employer-sponsored 401(k) plans, and the key difference is the kind of tax advantage they offer:

  • The traditional 401(k) lets employees save for retirement on a pre-tax basis, meaning you won’t pay taxes on any contributions. The money in the account can grow tax-deferred until withdrawn at retirement, defined as starting at age 59 ½. When withdrawn in retirement, any funds are taxed at ordinary income rates. After age 72, you will have to take required minimum distributions each year. Importantly, regardless of your income, a traditional 401(k) is always tax deductible.
  • The Roth 401(k) lets employees save for retirement using after-tax money, meaning you’ll pay taxes on any contributions. However, the money in the account can grow tax-free and then withdrawn tax-free in retirement, defined as age 59 ½ or later. After age 72, you will have to take required minimum distributions. However, you can generally roll a Roth 401(k) into a Roth IRA with few or no tax consequences.

Those are the largest differences between the two kinds of 401(k) plans, but one employer’s plan may differ in important ways from another’s, so it’s important that you read the fine print on your plan to see what it allows and does not allow.

Employee contributions to a 401(k)

Employee contributions to a 401(k) plan are limited to $20,500 in 2022. Employees can have the money seamlessly deducted from their paychecks and deposited into their account, making it easy for employees to participate in the plan and not feel as if they’re missing the money.

If they’ve opted to purchase mutual funds as part of their plan, the money will be automatically invested in those funds, according to the investment plan.

Employer matching contributions to a 401(k)

Many employers provide a matching contribution for some or all of an employee’s 401(k) contribution, incentivizing employees to participate in the plan. Matching contributions are considered to be traditional 401(k) deposits, even if the employee contributes to a Roth 401(k).

For example, some employers may match 50 percent of an employee’s contributions up to eight percent of salary each year. If the employee contributed eight percent, the employer would add another four percent, and the employee would effectively enjoy a total of 12 percent saved. But if the employee contributed 10 percent, the employer would still add a maximum of four percent.

Employers offer different matching amounts, and some employers may offer no match at all.

Many employers require matching contributions to vest over time. For example, if the employer requires three years of vesting, employees must remain with the company at least three years before any matching funds become fully theirs. However, once the employee has surpassed the vesting period, any subsequent matching funds immediately become theirs.

Matching funds may partially vest, depending on the employee’s length of service. For example, with a three-year vesting schedule, an employee who stays two full years may be able to keep two-thirds of any matching funds. But the rules depend on the details in the employer’s plan.

What are the pros and cons of a 401(k)?

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

Is it better to have a 401(k) or an IRA?

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, advisors 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.

Other key differences between the 401(k) and an IRA

But it’s worth pointing out some key differences between the two so that you can prioritize the one that works better for you:

  • IRAs are 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 at most brokers. In contrast, to get a 401(k), you’ll have to work at a company that offers one.
  • 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. With an IRA, you’re on your own.
  • 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. With a 401(k) plan, you’ll have only the choices available in that specific plan, often no more than a couple dozen mutual funds.
  • Only a Roth IRA has no required minimum distributions. The traditional 401(k), Roth 401(k) and traditional IRA all have required minimum distributions starting at age 72. Only the Roth IRA allows you to escape this stipulation.
  • 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 aren’t in that position (though robo-advisors can help out here). That’s where a 401(k) may offer a better option for workers, even if the investment selection is more limited. Usually, the investment choices are decent, even if they aren’t the best, and some 401(k) plans may offer advice or coaching, too.
  • 401(k)s offer higher contribution limits. The 401(k) is simply objectively better. The employer-sponsored plan allows you to add much more to your retirement savings than an IRA – $20,500 compared to $6,000 in 2022. Plus, if you’re over age 50 you get a larger catch-up contribution maximum with the 401(k) – $6,500 compared to $1,000 in the IRA.
  • Contributions to a traditional 401(k) are always tax-deductible. Your contributions to a traditional 401(k) are always tax-deductible, regardless of income. In contrast, contributions to a traditional IRA may or may not be tax-deductible, depending on income and whether you’re already covered by a 401(k) plan at work.
  • It’s easier to set up a Roth with an IRA. Both the 401(k) and the IRA have a Roth version, allowing money to grow and be withdrawn tax-free at retirement. While not all employers offer a Roth 401(k), anyone who qualifies for a Roth IRA can open one.
  • 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. Like a normal loan, you’ll have to pay interest, and you’ll have a repayment period, typically not more than five years. But the rules differ from plan to plan, so check the specifics of your plan.
  • A 401(k) is more secure from creditors. The 401(k) is more secure from creditors than the IRA, for example, in the event of a bankruptcy or an adverse lawsuit. However, the IRA or a spouse may still be able to come after the funds even then.

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