IRA vs. 401(k): Key differences and how to choose

Decoding retirement savings is as thrilling as an all-day cram session for a standardized test.

But just like that grad school exam, your future kinda depends on it.

401(k)s and IRAs can be confusing — even to someone who’s been writing about them for years — so I’m going to give you a simplified comparison that will help you decide which to prioritize as you save for retirement.

Let’s look at the advantages and disadvantages of an employer-sponsored 401(k) vs. a self-directed IRA.

What is a 401(k)?

A 401(k) is a tax-advantaged retirement plan offered by employers. Employees choose a portion of their pretax salary to be deducted from each paycheck, which will be invested in assets (typically mutual funds) chosen by the 401(k)’s administrator. Contributions in a 401(k) grow tax-free.

Employers often incentivize employees to contribute to a 401(k) by matching employees’ contributions, in full or in part.

Pros and cons of a 401(k)

Pros

• High contribution limits
• Employers might match contributions
• Automatic retirement savings
• Suitable for all levels of investment knowledge

Cons

• Offered to employees only
• Limited choice of investments
• May charge high fees
• Hard to avoid penalties on early withdrawals

What is an IRA?

IRA stands for ‘individual retirement account.’ IRAs differ from 401(k)s in that they are not sponsored by an employer, and are available to anyone with earned income.

Like a 401(k), contributions to an IRA grow tax-free. But unlike a 401(k), the contributions aren’t matched.

Because IRAs aren’t affiliated with a specific employer, investors can choose from a number of IRAs offered by banks and brokers nationwide. An investor can also take a free hand in choosing which assets to hold in an IRA they open.

Pros and cons of an IRA

Pros

• Accessible to virtually anyone
• Wide range of possible investments
• Easier to find low-fee options
• Offers more loopholes for penalty-free withdrawals
• Roth IRAs can be transferred to heirs tax-free

Cons

• Low contribution limits
• No contribution matching
• Requires more investment knowledge

Key differences between a 401(k) and an IRA

Employer matching

If your employer offers a 401(k), there’s a good chance they’ll match your contributions to some degree. In other words, they’ll give you free money for contributing to your 401(k).

Now, how much they give you varies substantially from one employer to the next. Many employers match up to 50% of your contribution, capped at a specific amount of your total salary, like 3% or 6%. But no matter what the match rate is, an employer’s contributions won’t count toward an employee’s annual 401(k) contribution limits (see below).

Because IRAs are individual plans rather than employer-sponsored plans, there’s no equivalent opportunity for a contribution match.

Contribution limits

The whole point of 401(k)s and IRAs is that Uncle Sam is giving you a break on your taxes to encourage you to save for your retirement. Unfortunately, there’s a limit to this generosity.

In 2024, savers under age 50 can contribute up to $23,000 to a 401(k), but only $7,000 to an IRA. Those age 50 or older can also contribute extra ‘catch-up’ amounts of $7,500 and $1,000 annually to 401(k)s and IRAs respectively. The max for combined employee-employer contributions in total to a 401(k) is $69,000 combined.

When you’re just starting out in the professional world, contribution limits are hilarious. There’s no way most of us will come close to them initially. But as you earn more money, pay off debt, and get serious about saving for retirement, it’s another story.

If you’re saving in an IRA only, $7,000 in annual contributions likely won’t be enough to fully fund the kind of retirement you’re dreaming about. But a 401(k)’s annual limit is plenty of room for even the most aggressive savers, at least until you start to seriously advance in your career. There’s also the possibility to max out both when you’re at that point.

Investment options

With an IRA, you can invest in virtually anything. You can have an IRA that simply holds a savings account, or an IRA with 100 different stocks, bonds, ETFs, and mutual funds.

With a 401(k), this usually isn’t the case. Your employer typically partners with an external financial services company to administer your plan. That company then gives you a limited number of investment options. Usually, but not always, these are made up of mutual funds.

If you work at a large company you may have a lot of investment choices within your 401(k). If you work for a very small company, however, you may only have 10.

For the average Joe/Jane, having fewer investment options might actually be a good thing. Most of us aren’t stock pickers and shouldn’t try to be architects of the perfect portfolio with hundreds of mutual funds.

That said, more experienced investors might feel restricted by the options in their company’s 401(k), and might prefer the freedom of an IRA. Furthermore, mutual funds charge hidden management fees, and some 401(k)s only offer mutual funds with unnecessarily high fees that eat away at your investment returns.

Tax advantages

Here are how taxes relate to each option.

Traditional 401(k)s and IRAs

Normally, if you earn $500 and want to invest it in Apple stock, you first have to pay income taxes on your earnings. So you’d pay something like $100 of taxes and use the remaining $400 to buy Apple shares. Assuming you hold these shares for many years, when you sell them, you’ll need to pay taxes on the amount the shares have appreciated, called capital gains tax.

With a traditional 401(k), you don’t have to pay income tax on the money you contribute. So in this circumstance, you would earn $500 and invest the full $500.

Contributions to a traditional IRA can also be tax deductible, provided neither you nor your spouse have an employer-sponsored retirement plan as well, e.g., a 401(k). If you do have an employer-sponsored retirement plan, IRA contributions are only fully tax deductible if your annual income falls below a specific limit ($77K for singles and $123K for married couples in 2024).

For both traditional 401(k)s and IRAs, you’ll pay income tax on the money you withdraw from the plans and/or on the mandatory disbursements made from the plans after you reach age 72. This taxation structure is advantageous to those who are at or near the peak of their professional careers, and who expect to have lower income in their retirement years.

Roth 401(k)s and IRAs

Roth 401(k)s and IRAs work differently, in that your contributions are taxed as regular income, but your withdrawals in retirement aren’t taxed.

This taxation structure is advantageous to contributors who expect to have a higher income in their retirement years than their current income, e.g., for those who are just starting out in their professional careers.

The Roth IRA estate planning advantage

Roth IRAs are unusual in that they can be passed down to your heirs intact, and your heirs don’t have to pay taxes on the inheritance. That perk isn’t offered with 401(k)s or traditional IRAs.

Withdrawal penalties

Here’s the thing about retirement accounts: They’re meant for retirement.

That means there are early withdrawal penalties.

If you withdraw cash from a traditional 401(k) or IRA before you turn 59^1/2, you will owe a 10% penalty on the withdrawal amount to the IRS, on top of ordinary income taxes.

That said, IRAs provide a bit more flexibility in this arena, and there are a number of exceptions to the IRA early withdrawal penalty. You can, for example, use penalty-free withdrawals to cover higher education expenses and up to $10,000 toward the purchase of your first home (or any home, provided you haven’t been a homeowner for the previous two years).

A Roth IRA is even more flexible, in that you can make penalty-free withdrawals from it at any age and for any reason up to the amount of your total contributions (not including earnings/growth within the account).

By contrast, with a 401(k) you must prove severe financial hardship to obtain an exemption from the early withdrawal penalty.

Some employers, however, allow you to take out a 401(k) loan. Essentially, you borrow money from yourself. Although this sounds like a great idea, it’s a slippery slope. Any money you borrow ceases to earn returns for you and, if you lose your job, you must repay the entire loan or pay income taxes and the 10% penalty on the outstanding balance.

Can I put off saving for retirement?

Someday your will to work will disappear. Your bills, unfortunately, won’t.

So, in most circumstances, no, you can’t put off saving for retirement. And the longer you put it off the less you’ll reap the benefits of compound interest.

Whatever excuse you have for not saving for retirement probably falls into one or more of the below three categories.

• I can’t spare the money.
• I feel like I don’t know enough about investing or my plan.
• I don’t like the investment.

Now, let’s debunk some of these common excuses one by one:

You can spare at least some money for retirement

It’s hard to set money aside when Two-Buck Chuck is your go-to drink and your iPhone is still on your parent’s family plan. I totally empathize with that.

But even if you can only contribute 1% of your paycheck to a retirement plan, at least that’s something.

What’s most important is that you:

1. Take the money you can spare and automatically invest it into either a 401(k) or IRA.
2. Try to max out your employer’s 401(k) match.
3. If you’re not an employee, invest whatever you can save in a balanced IRA portfolio of stocks and bonds. Don’t create an IRA comprised of low-risk investments, like CDs.

You can learn about investing

No problem! You can still save for retirement while you gradually improve your investing savvy.

The folks managing your company’s 401(k) are knowledgeable enough to invest your money for you. And if you don’t have a 401(k), most of the top robo-advisors today offer IRAs.

What if your company’s 401(k) is underwhelming?

That’s definitely a bummer, but not an excuse to avoid investing for retirement. Pivot!

If you’re savvy enough to realize that there are better options out there than your company’s 401(k), you’re probably savvy enough to open your own IRA and take personal control of your investments.

Are there reasons not to save for retirement right now?

There are some exceptions in that they’re excuses, but valid excuses.

You have high-interest debt

Ok, you found one of only two justifiable excuses not to save for retirement. At least not yet.

When you’re paying 10% or more in interest on credit card debt, you should direct whatever money you save each month toward repaying your card balance.

But once you’ve paid that debt off, it’s time to contribute aggressively to your retirement plan! Take whatever earnings you were allocating toward debt repayments and contribute them to your 401(k) or IRA instead.

You don’t have an emergency fund

It’s a good idea to gradually save up a healthy emergency fund before you start focusing on saving for retirement. Divert part of each paycheck until you have three months to one year’s worth of savings accumulated in an interest-bearing but liquid account, like a high-yield savings account. You can use an emergency fund calculator if you’re not sure how many months’ expenses you should save.

Once your emergency fund is full, you know the drill: Shift focus and contribute the monthly sum you formerly deposited into your emergency fund into your 401(k) or IRA instead.

Summary

For those eligible, 401(k)s are definitely the easiest way to save for retirement. The money is automatically taken out of your paycheck, and the limited choice of investments can actually be a good thing, as it simplifies your decision-making process.

The 401(k) employer match is also a major draw. Over time a good employer match can actually allow you to retire years earlier than you would have otherwise.

These considerations likely make the 401(k) the best retirement vehicle for most of our readers.

That said, there’s no shortage of freelancers out there that don’t have access to a 401(k). And most young professionals stand to benefit more from an IRA’s tax advantages, which favor lower-income contributors.

If you fall into more than one of the above categories, e.g., you have access to an employer-sponsored 401(k) but you haven’t reached your peak earning years, consider the following classic approach to retirement saving:

1. Contribute enough to your employer’s 401(k) so that you max out their contribution match.
2. Invest any remaining money you can save into an IRA.
3. Rinse and repeat until your income is high enough that you can hit the contribution limits for both a 401(k) and an IRA.

FAQs relating to your 401(k) vs IRA

Is a 401(k) an IRA?

A 401(k) is not the same thing as an IRA. Both are types of retirement accounts, but they differ in a few key ways. The most important difference is that 401(k)s are offered by employers, whereas IRAs are available to anyone who has earned income.

Can you lose money in a 401(k) or IRA?

The assets held in 401(k)s and IRAs can rise or fall in value as the market fluctuates, so, yes you can lose money in either a 401(k) or IRA.

But properly diversified portfolios are likely to appreciate in value over time. And you can adjust your 401(k) or IRA’s asset allocation to match your risk tolerance.