Retirement might seem like a distant event, but life moves fast. So, investing money for retirement as early as possible—like, now—is extremely important. It can help ensure you’re ready to retire comfortably when the time comes.
Fortunately, you’ve got several options if you’re looking for a retirement savings vehicle. Individual retirement accounts (IRAs) and 401(k) plans are the two most common types of retirement accounts, and they both can be excellent places to stash some cash for the future. But these accounts work differently, and each has its own benefits and drawbacks.
If you’re ready to dive in and start saving for retirement, or if you just want to refocus your retirement savings strategy, here’s what you need to know when conducting an IRA vs. 401(k) plan comparison.
Related: Retirement Saver’s Tax Credit: What Is It, How Much, Who’s Eligible + More
What Is an Individual Retirement Account (IRA)?
Before jumping into our IRA vs. 401(k) plan evaluation, let’s take a quick look at each type of retirement account—starting with IRAs.
An IRA is a retirement savings account you set up on your own through a brokerage firm. You can open a traditional IRA or a Roth IRA, and each option has its own tax advantages, which we’ll discuss shortly.
How Can You Contribute to an IRA?
You can fund your IRA with an ACH transfer from your bank or a personal check. Bank transfers can be made online through your brokerage account or you can send a check directly to your brokerage firm.
You can also roll over funds from an existing retirement account into an IRA.
What Are the Annual Contribution Limits for an IRA?
For 2023, the annual contribution limit for a traditional or Roth IRA is $6,500 if you’re under age 50, or $7,500 if you’re 50 or older. (This extra $1,000, which is only allowed for people who are at least 50 years old, is called a “catch-up” contribution.) The annual limit is a combined limit that applies to all your traditional and Roth IRAs.
Roth IRAs also have income limits, which is something to be aware of if you’re a high-earner. The 2023 annual contribution limit for Roth IRAs starts to phase out and is eventually reduced to zero if your modified adjusted gross income (AGI) is:
- $218,000 to $228,000 if your tax filing status is married filing jointly or surviving spouse
- $138,000 to $153,000 if your filing status is single, head of household, or married filing separately and you didn’t live with your spouse at any time during the year
- $0 to $10,000 if your filing status is married filing separately and you lived with your spouse at any time during the year
What Investment Choices Are Available With an IRA?
With an IRA, you’ll generally have a wide variety of investment options, including mutual funds, exchange-traded funds (ETFs), stocks, bonds, money market funds, and annuities.
Traditional IRA vs. Roth IRA
With a traditional IRA, your contributions are made with “pre-tax” dollars, which generally means contributions are tax-deductible in the year you make them (although your tax-deductible contributions might be limited if you or your spouse is covered by a workplace retirement plan or your income is too high). You then enjoy tax deferred investment growth once funds are in a traditional IRA, but the money is subject to ordinary income taxes when you make withdrawals in retirement.
On the other hand, contributions to a Roth IRA are made with “after-tax” dollars, which means they aren’t tax-deductible. However, funds in the account grow tax free, so you won’t pay taxes on withdrawals in retirement.
When Can You Withdraw Money From an IRA?
There’s nothing stopping you from taking money out of an IRA before retirement. However, if you pull funds out of an IRA too early, you might be hit with additional taxes and penalties.
With a traditional IRA, if you withdraw money earlier before turning 59½ years of age, you’ll pay a 10% early withdrawal penalty. The penalty is in addition to the taxes imposed on any distributions from a traditional IRA.
Roth IRAs work a bit differently. Any contributions you make to a Roth can be withdrawn tax free and penalty free at any time. But if you withdraw investment gains before age 59½, you’ll likely pay taxes and the 10% early withdrawal penalty.
Penalty-free withdrawals from either a traditional or Roth IRA are possible under certain circumstances, including to pay certain education expenses and a one-time withdrawal of up to $10,000 for a first-time home purchase.
You’re also required to take out a certain amount of money from a traditional IRA each year when you turn 73 years old. These mandatory withdrawals are called required minimum distributions (RMDs). They aren’t necessary with Roth IRAs, though.
Related: 529 Qualified Expenses: How to Spend Your Education Savings
SIMPLE and SEP IRAs
In addition to traditional and Roth IRAs, small business owners (including self-employed people) can also open a SIMPLE IRA or SEP IRA for themselves and their employees.
In a way, SIMPLE and SEP IRAs are like 401(k) plans in that they’re all employer-sponsored retirement accounts. However, as discussed later, there are many important differences between these types of IRAs and 401(k) plans.
Related: SEP IRA vs. Roth IRA: What’s the Difference?
What Is a 401(k) Workplace Retirement Plan?
Unlike an IRA, a 401(k) plan is a retirement savings plan established by your employer. The employer-sponsored retirement accounts set up under a 401(k) plan can be either a traditional or Roth account, depending on what your company offers. Each has its own tax benefits, which we’ll cover momentarily.
How Can You Contribute to a 401(k)?
Unlike contributions to a Roth or traditional IRA, employee contributions to your 401(k) account generally come right out of your paycheck. You can’t transfer money into a 401(k) account from your bank account or contribute to your 401(k) account with a paper check.
What Are the Annual Contribution Limits for a 401(k)?
For 2023, employees under 50 years old can contribute a total of $22,500 to a 401(k) plan, while workers who are at least 50 years old can put in up to $30,000.
Employers can contribute up to $43,500 of additional funds to an employee’s account for 2023, or a total of $66,000 for workers under 50. (The limit is $73,500 for older employees who make catch-up contributions.) However, regardless of a worker’s age, an employer can’t put in more than a worker’s annual compensation from the company.
How Do Employer Matching Contributions Work?
Employers can contribute to a 401(k) plan on behalf of their employees. For example, a company might match employee contributions by a certain percentage, such as 3% or 6%.
In other cases, an employer match can be a predetermined amount based on the employee’s annual contribution (e.g., a dollar-for-dollar matching contribution for the first $1,500 an employee contributes to his or her own 401(k) account during the year).
Regardless of the type of employer match, the combined total employee and employer matching contributions can’t exceed the $66,000 or $73,500 caps for 2023.
What Investment Choices Are Available With a 401(k)?
The type of investment options available with a 401(k) varies by employer, but the investment choices are usually more limited than what’s available with an IRA. Most 401(k) plans only offer mutual funds. A handful let you invest in ETFs, individual stocks, and more.
If you’re curious about your employer’s 401(k) investment options, contact your company’s benefits office for more information.
Traditional 401(k) vs. Roth 401(k)
As with IRAs, the primary difference between traditional 401(k) and Roth 401(k) accounts is when money put in the account is taxed.
Contributions to a traditional 401(k) are not included in an employee’s taxable income, but withdrawals are taxed in retirement.
With a Roth 401(k), contributions are considered taxable income in the year the contribution is made, but withdrawals aren’t taxed in retirement.
When Can You Withdraw Money From a 401(k)?
The 10% early withdrawal penalty applicable to IRAs generally applies to 401(k) accounts, too. So, with a traditional 401(k) account, you might have to pay the penalty if you withdraw money from the account before you turn 59½ years old. And, with a Roth 401(k) account, you could be hit with the penalty if you withdraw earnings before reaching 59½ years of age.
However, when it comes to exceptions to the early withdrawal penalty, the rules for IRAs and 401(k) plans don’t alway match up perfectly. For instance, you can’t avoid the penalty by taking money out of a 401(k) account to pay education costs or buy a first home like you can with an IRA.
In addition, if you lose or leave a job in or after the year you turn 55, you can start taking withdrawals from that company’s 401(k) plan without incurring a penalty. You can’t do that with an IRA.
Required minimum distributions are also mandatory for both traditional and Roth 401(k) accounts right now once you turn 73. However, starting in 2024, required minimum distributions will no longer be required for Roth 401(k) accounts.
Related: Should You Max Out Your 401(k) Each Year?
IRAs vs. 401(k) Plans: Key Differences
Now that we’ve presented a broad overview of how IRAs and 401(k) plans work, let’s do a side-by-side comparison of the key differences between these two types of tax-advantaged accounts.
The following IRA vs. 401(k) comparison table highlights the most important differences to consider when putting together your retirement savings plan. Hopefully, by presenting the information in this format, you’ll have a better idea of the pros and cons of each account.
| IRAs | 401(k) Plans | |
|---|---|---|
| Who Creates Account | Individual account holder | Employer |
| Contribution Source | Individual account holder | Contributions generally come out of an employee’s paycheck, but employer contributions are optional |
| Contribution Limits (2023) | $6,500 | $22,500 |
| Catch-Up Contributions (2023) | $1,000 | $7,500 |
| Investment Options | Investment options often include mutual funds, ETFs, stocks, bonds, and more | Investment options typically include mutual funds, although investments vary by employer |
| Taxation of Contributions | ● Traditional: Generally tax-deductible for employee ● Roth: Not tax-deductible for employee | ● Traditional: Excluded from employee’s taxable income ● Roth: Included in employee’s taxable income |
| Required Minimum Distributions | ● Traditional: Yes ● Roth: No | ● Traditional: Yes ● Roth: Yes, until 2024 |
Related: Best Investments for Roth IRA Accounts
How Do SIMPLE IRAs and SEP IRAs Compare to 401(k) Plans?
SIMPLE and SEP IRAs are special types of IRA accounts that employers create on behalf of their employees. They’re similar to a 401(k) plan in this way, but beyond that, these accounts are very different.
Let’s take a peek at how they each compare to 401(k) plans.
SIMPLE IRAs vs. 401(k) Plans: Key Differences
While a 401(k) plan is available to businesses of any size, a SIMPLE IRA is for small businesses with no more than 100 employees who received at least $5,000 in compensation from the business in the preceding year. An employer offering a SIMPLE IRA can’t also have another retirement plan, either.
Both accounts allow both employers and employees to make contributions, though employer contributions are mandatory with a SIMPLE IRA. For 2023, an employer must contribute one of the following to each eligible employee’s account:
- A dollar-for-dollar match of the employee’s contribution, up to 3% of the employee’s compensation
- 2% of the first $330,000 of the employee’s compensation
There are no Roth-style SIMPLE IRAs, so all withdrawals are subject to tax.
Here’s a quick look at some of the important differences between SIMPLE IRAs and 401(k) plans.
| SIMPLE IRAs | 401(k) Plans | |
|---|---|---|
| Best For | Small businesses with fewer than 100 employees | Larger businesses |
| Contribution Source | Employer contributions are mandatory; employee contributions are optional | Employee and employer contributions are optional |
| Contribution Limits (2023) | ● Employee contributions: $15,500 ● Employer contributions: Up to 3% employer match or 2% of compensation | ● Employee contributions: $22,500 ● Employer contributions: $43,500 |
| Catch-Up Contributions (2023) | $3,500 | $7,500 |
| Taxation of Contributions | ● Employee contributions: Excluded from taxable income ● Employer contributions: Tax deductible | ● Employee contributions: Traditional 401(k) contributions excluded from taxable income; Roth 401(k) contributions included in taxable income ● Employer contributions: Tax deductible |
| Required Minimum Distributions | Yes | Yes, but not for Roth 401(k) accounts after 2023 |
SEP IRAs vs. 401(k) Plans: Key Differences
The SEP IRA is another type of workplace retirement account for small businesses. These accounts are generally best for very small companies or sole proprietors.
Unlike a 401(k) plan, employees can’t contribute to a SEP IRA. Instead, employers establish these accounts on behalf of their employees and are the sole contributors to them. The contribution amount is a percentage of the employee’s compensation (up to $330,000 for 2023), but the percentage must be the same for all eligible workers.
Annual contribution limits for SEP IRAs are significantly higher than those of 401(k)s. However, catch-up contributions aren’t allowed with SEP IRAs.
Like SIMPLE IRAs, all SEP IRAs are considered traditional IRAs. As a result, contributions are tax-free, but withdrawals are taxable.
Here’s how SEP IRAs compare with 401(k) plans in certain key areas.
| SEP IRAs | 401(k) Plans | |
|---|---|---|
| Best For | Very small businesses | Larger businesses |
| Contribution Source | Employer contributions are mandatory; employees can’t contribute | Employee and employer contributions are optional |
| Contribution Limits (2023) | 25% of employee’s compensation or $66,000, whichever is less | ● Employee contributions: $22,500 ● Employer contributions: $43,500 |
| Catch-Up Contributions (2023) | Not allowed | $7,500 |
| Taxation of Contributions | Tax deductible for employer | ● Employee contributions: Traditional 401(k) contributions excluded from taxable income; Roth 401(k) contributions included in taxable income ● Employer contributions: Tax Deductible |
| Required Minimum Distributions | Yes | Yes, but not for Roth 401(k) accounts after 2023 |
Related: Solo 401(k) vs. SEP IRA: What’s the Difference?
Additional IRA vs. 401(k) Questions
Here are answers to a few other frequently asked questions about the relationship between IRAs and 401(k) plans.
Can You Have a 401(k) Plan and an IRA?
Yes, you can have a 401(k) plan and an IRA, which is great news if you’re building a retirement nest egg. For 2023, you can contribute a total of $22,500 to 401(k) plans and a total of $6,500 to IRAs ($30,000 and $7,500, respectively, if you’re at least 50 years old).
But there’s one important tax consequence to consider: If you’re covered by a retirement plan at work and contribute to a traditional IRA, it’s possible only a portion of your traditional IRA contributions will be tax-deductible. The amount you can deduct depends on your total annual income, and deductions for the 2023 tax year start to phase out for single people once their modified AGI exceeds $73,000 ($116,000 for married couples filing a joint tax return).
Your deduction can also be phased out if your spouse is covered by a workplace retirement plan. The 2023 deduction reduction begins for joint filers when their modified AGI is more than $218,000.
Can You Roll Over a 401(k) Into an IRA?
You can roll over a 401(k) plan into an IRA, but be mindful of the rollover’s tax treatment. If you have a Roth 401(k), you can roll over your account into a Roth IRA without paying taxes on your balance (you can’t roll it over into a traditional IRA). You get the same result if you roll over a traditional 401(k) to a traditional IRA—no taxes at that time.
But if you have a traditional 401(k) and you roll it over into a Roth IRA, it’ll be treated as a Roth conversion. In this case, you’ll have to pay ordinary income taxes on the amount you transfer.
YATI Tip: If you have $5,000 or less in a 401(k) plan when you leave a job, your former employer might automatically distribute the funds to you directly (if $1,000 or less) or roll the money into an IRA (if between $1,001 and $5,000).
Are IRAs and 401(k) Plans Protected From Creditors?
With a 401(k), your money is generally protected from creditors if you’re sued or you file for bankruptcy. These protections are granted under the federal Employee Retirement Income Security Act (ERISA) that was passed in 1974.
While IRAs don’t qualify as ERISA-protected accounts, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) protects up to $1,512,350 of your IRA account balance if you file for bankruptcy (the dollar amount will be adjusted for inflation on April 1, 2025). Otherwise, protection against creditors for IRAs is generally governed by state law.
Is It Better to Have a 401(k) or IRA?
One isn’t necessarily better than the other, and it can make sense to have both. With a 401(k), you’ll benefit from higher contribution limits, and with an IRA you’ll likely get more investment options.
Many people choose to contribute to a traditional 401(k) and a Roth IRA for tax diversification, as the tax treatment for these accounts is different. With a traditional 401(k), you’ll benefit from a current-year tax deduction and withdrawals will be taxed in retirement. With a Roth IRA, you won’t get a tax deduction when you contribute to the account, but your withdrawals won’t be taxed in retirement.
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