401(k) vs. IRA: An Overview
Individuals can save for retirement through 401(k) plans and individual retirement accounts (IRAs). A 401(k) is an employer-sponsored retirement plan. An IRA is an individual retirement account that individuals open through a bank or a brokerage firm. Both a 401(k) and an IRA can invest in stocks, bonds, and securities.
Most IRAs and 401(k)s do not allow withdrawals before the owner reaches the age of 59½. Any money taken out before that age incurs a tax penalty by the Internal Revenue Service (IRS). There can be exceptions to the early withdrawal penalty depending on the specific retirement account and a person’s financial situation
Key Takeaways
- 401(k) plans are tax-deferred retirement savings accounts.
- Employers offer 401(k)s 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)
Employers may offer participation in a defined-contribution plan such as a 401(k). Employees contribute a percentage of their salary to their 401(k) and the employer may match contributions up to a specific limit. Contributions to 401(k) accounts are made pretax, meaning the total of the contributions reduces taxable income for that year by the contribution amount. If an employee earned a $50,000 salary and contributed $10,000 to a 401(k), then the taxable income for the year would be $40,000.
Investment vehicles commonly include mutual funds selected by the sponsor. The fund choices are designed to meet a specific risk tolerance for employees. Investment income accrues and compounds tax-deferred.
Many employers offer Roth 401(k)s. Unlike a traditional 401(k), contributions are funded with after-tax money and not tax-deductible. Withdrawals are taxed at the person’s income tax rate, and there’s no penalty for withdrawals as long as the distributions are made at age 59½ or older. Qualified withdrawals, though, are tax-free. These include hardship withdrawals or those made for medical reasons.
To receive the employer match, the employee may need to contribute a minimum amount or percentage of their salary. It’s important to review the 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
Individuals can save on their own by opening an IRA and have a 401(k) and an IRA. IRAs don’t provide matching contributions from an employer. Various types of IRAs have specific income and contribution limits and tax advantages. Traditional IRAs and 401(k)s are tax-deferred until the funds are withdrawn. As with 401(k) plans, IRA holders can begin withdrawals after they reach age 59½. Withdrawals before that age incur a 10% tax penalty unless used for a hardship withdrawal.
An IRA can be a savings account or certificate of deposit (CD) at a local bank or held by brokerage and investment firms, offering investment options in stocks, bonds, CDs, and even real estate.Contributions to traditional IRAs are generally tax-deductible. Earnings and returns grow tax-free and are taxed on withdrawals in retirement.
Contributions to a Roth IRA are made with after-tax dollars, meaning individuals don’t receive a tax deduction in the year of the contribution; however, qualified distributions from a Roth IRA are tax-free in retirement.
Unlike 401(k) plans, the IRS does not allow individuals to borrow against the balance of their IRA account.
Contribution Limits
The IRS has established limits on total contributions—by both employee and employer—to a 401(k). Total contributions may not exceed $66,000 or $73,500 with catch-up contributions in the tax year 2023. These amounts increase to $69,000 or $76,500 with catch-up contributions in 2024. Alternatively, the total contribution to a 401(k) cannot exceed 100% of the participant's compensation.
Annual contribution limits are capped for IRAs like 401(k) plans. The contribution limits for traditional and Roth IRAs are $6,500 for the tax year 2023 with an additional $1,000 catch-up contribution allowed for people ages 50 and older. This limit increases to $7,000 in 2024. With the additional $1,000 catch-up contribution, people 50 and over can contribute $8,000 to an IRA in 2024.
Key Differences
The primary differences between 401(k) plans and individual retirement accounts are explained in the following table:
| IRAs vs. 401(k) Plans: 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 wide universe 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, SET, 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.) |
| IRAs vs. 401(k) Plans: 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 wide universe 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, SET, 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.) |
SEP and SIMPLE IRAs
Employers may offer a simplified employee pension (SEP) IRA, or a Savings Incentive Match Plan for Employees (SIMPLE) IRA if the company has 100 or fewer employees.They have fewer administrative burdens than 401(k) plans. For the self-employed, the term employer includes an owner/employee.
- SEP IRA: SEP IRAs have higher annual contribution limits than standard IRAs, and only an employer can contribute. Employer contributions can be as much as 25% of an employee’s gross annual salary. The annual contribution limit is $66,000 or $73,500 for those 50 and older for tax year 2023. These amounts increase to $69,000 or $76,500 with the catch-up contribution in 2024.
- SIMPLE IRA: SIMPLE IRA contributions work differently than SEP IRAs and 401(k)s. 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 $15,500 in 2023 and $16,000 in 2024. People 50 and over can make an additional catch-up contribution of up to $3,500 in 2023 and 2024.
How Much Do Employers Match to 401(k) Accounts?
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. If an employee contributes 6% of their salary, the employer will contribute a 3% match.
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 deduction for contributions, but withdrawals are tax-free in retirement. Traditional IRAs offer a tax deduction, while 401(k)s allow pre-tax income to be deposited, which reduces taxable income in the year of the contribution. Distributions from 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 penalty. The easiest way to ensure funds roll over penalty-free is with a direct rollover.
The Bottom Line
IRAs and 401(k) plans are investing tools with different strengths. Because a 401(k) is an employer-sponsored plan, individuals may have less ability to choose their investments, but contribution limits are higher than in a traditional or a Roth IRA.
