How is a 401(k) different from an individual retirement account (IRA)?
All retirement accounts serve one primary purpose: To help you save for retirement in a tax-advantaged manner. However, there are several types of retirement accounts, each with different ways of operating. The two most common are 401(k)s and Individual Retirement Accounts (IRAs). A 401(k) is typically sponsored by your employer, whereas you can open an IRA independently.
If you’re thinking about opening one or both of these retirement accounts, take a minute to get answers to these key questions:
What are the benefits and drawbacks of each?
What is a 401(k)?
A 401(k) is a workplace retirement plan your employer establishes. With a 401(k), you can contribute a percentage of your monthly wages. For instance, you might elect to contribute $100 from each paycheck to your 401(k).
Notably, the money you contribute to your 401(k) isn’t subject to income tax,* so you get an immediate tax break. In some cases, there is an employer match — your employer will match some of your contributions, which will help your retirement savings grow faster. Plus, contribution limits are significantly higher than those for IRAs.
What is an Individual Retirement Account (IRA)?
An IRA is a retirement account that you set up directly with a financial institution, usually a bank or a brokerage. There is no employer involvement. You can contribute to an IRA if you’ve earned income (from wages, self-employment, etc.).
There are two main types of IRAs: Traditional IRAs and Roth IRAs. The key difference between them is their tax benefits. With a traditional IRA, the portion of your earnings you contribute isn’t subject to income taxes, so you get an immediate tax break. But you’ll have to pay income tax when you withdraw the money in retirement. With a Roth IRA, there’s no upfront tax break — but you won’t have to pay taxes on your “qualified distributions” taken after age 59 ½. A financial or tax advisor can help you choose which may be more appropriate for you.
401(k)s vs. IRAs. A comparison
To fully understand how a 401(k) differs from an IRA, consider the following factors.
401(k) vs. IRA: Eligibility
401(k) | Traditional IRA | Roth IRA |
|---|---|---|
Must meet employer eligibility requirements. Rules vary by employer. No income limits, but earnings over $345,000 per year are ineligible for contributions. | Anyone with earned income can open a traditional IRA. | Most individuals with earned income can open a Roth IRA (single filers with income above $161,000 and joint filers with income above $240,000 cannot open a Roth IRA in 2024). |
401(k) vs. IRA: Contributions and tax benefits
401(k) | Traditional IRA | Roth IRA |
|---|---|---|
You can contribute up to $23,000 annually (in 2024), plus an additional $7,500 if you're 50 or older. | You can contribute up to $7,000 annually (in 2024), plus an additional $1,000 if you're 50 or older. | You can contribute up to $7,000 annually (in 2024), plus an additional $1,000 if you're 50 or older. |
Contributions are made with “pre-tax” dollars (you don’t pay taxes on the money you contribute).* | Contributions are made with after-tax dollars and are tax-deductible. | Contributions are funded with after-tax dollars and are not tax deductible. |
Some employers offer matching contributions. | Deductible contributions may be phased out if you are an “active participant” in an employer sponsored retirement Plan. | No employer-matching contributions. |
401(k) vs. IRA: Investment options
401(k) | Traditional IRA | Roth IRA |
|---|---|---|
Investment options may be limited, depending on the employer. | Investments are selected by the plan owner. | Investments are selected by the plan owner. |
The employer chooses an investment line-up. | Investment options usually include stocks, bonds, mutual funds, ETFs, money market funds, Certificates of Deposit (CDs), and more. | Investment options usually include stocks, bonds, mutual funds, ETFs, money market funds, Certificates of Deposit (CDs), and more. |
Employees may be able to choose from a selection of stocks, bonds, mutual funds, and money market accounts. Some employers also include life insurance. | Investment selection can vary depending on the institution where the IRA is opened. | Investment selection can vary depending on the institution where the IRA is opened. |
401(k) vs. IRA: Withdrawals and tax implications
401(k) | Traditional IRA | Roth IRA |
|---|---|---|
Withdrawals taxed as ordinary income.* | Withdrawals taxed as ordinary income. | Withdrawals of contributions are always tax-free (if certain conditions are met). |
10% penalty applies for withdrawals before age 59 ½ (exception for separation of service at age 55). | 10% penalty applies for most withdrawals before age 59 ½. | 10% penalty applies to most withdrawals of earnings before age 59 ½. |
Loans and In-service distributions may be available. | You can make penalty-free withdrawals before age 59 ½ for eligible expenses including college tuition or medical bills. | You can make penalty-free withdrawals of earnings before age 59 ½ for eligible expenses including college tuition and medical bills. |
Required minimum distributions begin at 73 years old (unless the plan allows for delay if you’re a non-owner and you are still working). | Required minimum distributions begin at 73 years old. | Withdrawals of earnings are tax-free if the account has been open for at least five years and the account owner is over age 59 ½. |
401(k) vs. IRA: Which is better for you?
Should you open an IRA, a 401(k) or both? The answer will depend on your current circumstances and your future financial and retirement goals. That said, here are some quick tips that may help you to decide.
A 401(k) may be best when:
You work for a company that provides employer matching
Matching involves an employer contributing company money to your account. Matching is not offered to IRAs (with the exception of Simple IRAs, which are uncommon), so this is a significant plus for 401(k) plans.You may want to take a loan from your account in the future
Some 401(k) plans allow you to take a loan from the account, then pay it back to yourself over time. IRAs do not have this feature.You want contributions taken out of your paycheck
A 401(k) allows you to elect to have a certain amount of money taken out of your paycheck each month automatically. IRAs do not have this feature (though you could set up automatic IRA contributions from your bank account).You can make large contributions
401(k)’s have a much higher annual contribution limit than IRAs ($23,000 per year vs. $7,000 per year for those under 50, $30,500 per year vs. $8,000 per year for those 50 and older).
A traditional IRA may work best when:
You are self-employed or want a plan not tied to your employer, as IRAs (both traditional and Roth) are opened and managed by you without employer involvement. Your investment options won’t be limited by employer restrictions.
You want to save money on taxes upfront: Traditional IRAs—but not Roth IRAs—lower your taxable income by giving you tax deductions, which can help you save money upfront.
A Roth IRA may work best when:
You are self-employed or want a plan that’s not tied to your employer
IRAs (both traditional and Roth) are opened and managed by you with no employer involvement. Your investment options won’t be limited by employer restrictions.You want the most flexibility possible
Roth IRAs allow you to withdraw your contributions at any time, tax-free and penalty-free. Withdrawing profits are subject to more rules, however.You prefer tax-free withdrawals in retirement
Withdrawals from a Roth IRA made after age 59 ½ (and after at least five years of account ownership) are entirely tax-free. With a 401(k) or traditional IRA, you still need to pay taxes on withdrawals, unless you’ve contributed to a Roth 401(k).You may be in a higher tax bracket after retiring
With a Roth IRA, you pay taxes today instead of in retirement. So, if, for whatever reason, you anticipate being in a higher tax bracket after retiring, you’ll probably save money because your withdrawals will be tax-free.
You can have both an IRA and a 401(k)
Finally, remember that you can have both a 401(k) and an IRA; in some cases, having both may be beneficial.
For instance, some people may have a 401(k) through their employer, and a Roth IRA on their own. This means they have both a pre-tax and post-tax retirement account, which can be helpful for tax planning and tax diversity.
If you do end up with multiple retirement accounts, make sure to keep an eye on the contribution rules. Contributions to a Traditional IRA may not be fully deducted if you are participating in an employer sponsored retirement plan. Also, keep in mind that you might already have a 401(k) from your current employer, a past employer, or both. Make sure to check your records and contact HR at past roles to make sure that you have access to all your accounts.
If you’re have trouble locating an old employer’s information you may try the National Registry of Unclaimed Retirement Benefits at https://unclaimedretirementbenefits.com/, or the Department of Labor’s abandoned plan database at https://www.askebsa.dol.gov/abandonedplansearch/.
If you were covered by an employer pension plan you may also search the U.S. Pension Benefit Guarantee Corporation database of unclaimed pensions at: https://www.pbgc.gov/wr/find-unclaimed-retirement-benefits.
Guardian can help
To learn more about the retirement planning process, you may want to consult a financial professional – or a tax advisor – who has specialized experience. If you don’t currently have someone to advise you, Guardian can help. A Guardian Financial Professional will listen to your needs, help define your goals, and help you to better understand the retirement planning process and make the right decisions. Here’s how to find someone near you: