IRA vs. 401(k): What’s the Difference?

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An IRA and a 401(k) are two common types of retirement accounts that offer tax advantages when you invest. The key difference between the two is that an IRA is a type of retirement account that you open, fund, and invest on your own, while a 401(k) is a retirement account you open through your employer.

If you want to know more about the differences between an IRA and a 401(k), you’re in the right place. Learn more about how each type of retirement account works, who can contribute, and which one makes sense for you.

What’s the Difference Between an IRA and a 401(k)?

An IRA is a tax-advantaged retirement account that stands for “individual retirement arrangement,” although it’s typically referred to as an individual retirement account. Typically, an IRA is an account you open for yourself as an individual. However, a few types of IRAs, such as a simplified employee pension (SEP) or a Simplified Incentive Match for Employees (SIMPLE) IRA, allow an employer to open and fund an account on your behalf.

A 401(k) is a type of retirement savings plan employers can set up on their workers’ behalf. As with an IRA, you get tax advantages for saving in a 401(k). Some companies also contribute to employees’ accounts. A 401(k) operates under the rules of the Employee Retirement Income Security Act (ERISA), a federal law that sets minimum standards for private-sector workplace retirement plans.

If you’re self-employed, you can open a solo 401(k) and make contributions as both the employee and the employer.

The tax advantages you get with an IRA versus a 401(k) depend on the type of account. The withdrawal rules also vary, however, if you take money out of either account before age 59 ½; you could owe taxes and a 10% penalty.

The two main types of IRAs are:

  • Traditional IRA: A traditional IRA is an IRA that lets you make tax-deductible contributions, depending on your income, tax filing status, and whether you’re covered by a workplace retirement account. Your money grows on a tax-deferred basis and is generally taxed when you withdraw it.
  • Roth IRA: A Roth IRA is a type of IRA you fund with post-tax dollars. Although you can’t deduct your contributions for tax purposes, your withdrawals are tax-free in retirement if you follow certain rules. You may also be penalized for withdrawing your earnings early, although you can access your contributions whenever you want without paying taxes or penalties.

With a traditional 401(k), you defer a portion of your income and get a tax break on your contributions. You’re taxed later on when you take distributions from the account.

As of 2020, nearly 90% of 401(k)s also offer a Roth option for employee contributions, according to the Plan Sponsor Council of America’s 64th Annual Survey of 401(k) and Profit Sharing Plans. A Roth 401(k) allows employees to make after-tax contributions and receive tax-free withdrawals once they reach age 59 ½ and have held the account for at least five years. However, employer contributions must be held in a separate account and are taxed upon distribution.

Eligibility

To contribute to an IRA, you need to have earned income for the tax year. Earned income essentially is money you earn from working, such as wages, salary, bonuses, tips and self-employment income. Investment income, Social Security benefits, unemployment benefits, annuities, and pensions don’t count. A Roth IRA also has income limits.

If you’re married and file a joint tax return, you’re also allowed to fund an IRA for your spouse, even if they have little or no earned income. You can contribute the lesser of the contribution limit times two or your combined income for the tax year through what’s often referred to as a “spousal IRA.”

You can only contribute to a 401(k) if your employer offers one. Generally, employers must allow employees to participate in the plan if the employees are at least age 21 with at least one year of service. Employers can set their own rules in their plan document, but the rules can’t be more restrictive. For example, a company could allow workers who are 18 years old or have only been at their job for six months to participate. But they couldn’t limit participation to employees over 25 or require two years of service.

Plan Limits

The IRA contribution limit for both 2021 and 2022 is $6,000 if you’re younger than age 50. If you’re age 50 or older, you’re allowed an additional $1,000 catch-up contribution for each tax year. The limits apply to both traditional and Roth IRAs.

You can only contribute the amount of earned income you have for the year. If you only make $4,000 in 2022, your maximum contribution for the year will be $4,000.

You have until Tax Day to make your IRA contribution for any given year. For example, the deadline to fund your IRA for 2021 is April 18, 2022.

The maximum 401(k) contribution for employees under 50 years of age is $20,500 in 2022, up $1,000 from 2021. Employees 50 years and older are allowed a $6,500 catch-up contribution in 2022, which is unchanged from 2021. Employee and employer contributions can’t exceed $61,000 or 100% of the employee’s total pay in 2022. However, the $6,500 catch-up contribution doesn’t count toward the limit.

Other Considerations

An IRA offers a lot more flexibility compared to a 401(k). You can open an IRA at the brokerage of your choosing. You can invest in whatever individual stocks, bonds, mutual funds, and exchange-traded funds (ETFs) your brokerage company offers.

You can only invest in a 401(k) through your employer. Your account is managed by the third-party administrator your company chooses. Your investment options are a lot more limited, although most plans offer at least three investment options, with mutual funds being the most common. However, according to the Plan Sponsor Council of America’s survey, the number of investment options for 401(k) plans is growing, with the average plan offering 21 fund choices as of 2020.

Which Is Right for You?

The good news is if you’re trying to choose between an IRA and a 401(k), you don’t have to choose one or the other. You’re allowed to invest in both types of retirement accounts, provided you meet eligibility rules. However, a lot of people don’t have room in their budgets to max out both an IRA and a 401(k).

A good rule of thumb is to prioritize your employer’s match. Suppose your company matches 50% of your contributions, up to 5% of your salary. That’s an automatic 50% return on your investment, so you’d want to take advantage. If you’re earning a $50,000 salary, aim to save at least $5,000, or 10% of your salary, so you can get your full match.

From there, you may want to fund an IRA if you have more money to invest. Once you’ve invested $6,000 (or $7,000 if you’re age 50 or older), you can allocate any leftover money you have to invest into your 401(k).

Key Takeaways

  • An IRA is a retirement account you open individually, while a 401(k) is a retirement account you open through your employer.
  • Both IRAs and 401(k)s have traditional options that you fund on a pretax basis and Roth versions that are funded with after-tax dollars.
  • You’re allowed to contribute to both an IRA and a 401(k) as long as you meet the eligibility rules.

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