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

In a nutshell

Saving for retirement is one of the most important aspects of planning for your financial future. To encourage retirement savings, the government has created specialized accounts that offer tax incentives. Two of the most popular are the Individual Retirement Account (IRA) and the 401(k). Both aim to help people build a retirement nest egg, but there are key differences in how they function.

• 401(k)s and IRAs both offer tax benefits to people who save for retirement.
• You will pay a penalty if you withdraw money from either account before retiring.
• Almost anyone can open an IRA, but 401(k)s only come from employers.

What is an IRA?

An IRA is a type of tax-advantaged retirement account. Almost anyone can open an IRA and they’re available at many banks and brokerages. They come in two forms, traditional and Roth, each offering different tax benefits.

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The amount you can contribute to an IRA each year is limited. Each year you can add only $7,000 ($8,000 if you’re over 50) to your IRAs. Additionally, the amount you can contribute or deduct from your income may be limited if you earn more than a certain amount. This limit is based on your tax filing status.

Because you can open an IRA at almost any brokerage, you have a lot of control over how the money is invested. You can invest in a variety of securities, including stocks, bonds, ETFs and mutual funds. Some companies also offer ways to invest your IRA in unusual asset classes.

What is a 401(k)?

A 401(k) is another type of tax-advantaged retirement account. Like IRAs, 401(k)s come in two forms: Roth and traditional — though traditional is more common. 401(k)s offer the same tax benefits as IRAs, in the form of tax deductions for contributions or tax–free growth.

What sets 401(k)s apart from IRAs is that they’re offered by employers as an employee benefit. Unless you’re self-employed or run a business, you can’t just go out and open a 401(k) for yourself. You need to get one through your employer.

That means that you have less control over how your 401(k) is invested. Usually, your employer will choose a company that provides the 401(k) and you’re given a list of investment options to choose from.

On the bright side, 401(k)s have much higher contribution limits. For 2024, you can contribute up to $23,000 ($30,500 if you’re 50 or older). Additionally, many employers will contribute to your 401(k) on your behalf. Usually, this comes in the form of matching contributions up to a percentage of your pay.

For example, your employer could offer a 100% match on the first 5% of your salary. If you make $50,000 per year, your employer would add $2,500 to your 401(k) so long as you contribute $2,500 per year.

When you leave your employer, you can choose to keep your 401(k) as is or roll the balance into an IRA.

What’s the difference between IRAs and 401(k)s?

IRAs and 401(k)s are both designed for the same purpose: helping you save for retirement. Still, there are significant differences that you need to pay attention to.

Do you have to choose between an IRA and a 401(k)?

No, there is no need to choose between an IRA and a 401(k). It’s possible to open both types of accounts and contribute to both at the same time. The two do not share the same contribution limits, so, if you have enough money to do so, you can max out both accounts to take full advantage of the tax benefits.

IRA vs. 401(k) taxes and withdrawals

IRAs and 401(k)s come in two main forms: traditional and Roth. You can sometimes choose whether to open a traditional or Roth IRA when you open the account. There’s nothing stopping you from opening both types, but keep in mind that they share a contribution limit.

Your employer chooses whether to offer a traditional or Roth 401(k). Some may offer both, but traditional 401(k)s tend to be more common.

When you contribute to a traditional IRA or 401(k), you can deduct the amount of money you’ve contributed to the account from your income when filing your taxes. That means you pay less tax upfront. When you withdraw money, you pay taxes on the withdrawal as if it were income.

Roth IRAs and 401(k)s flip those benefits. You pay taxes as normal when making contributions, but withdrawals are not taxed.

With both Roth and traditional accounts, withdrawals before you turn 59 ½ are typically subject to a 10% early withdrawal penalty, plus any applicable taxes.

Combining IRA and 401(k) accounts

If you have multiple of the same type of IRA, you can combine them relatively easily. For example, you can combine two traditional or two Roth IRAs into a single account by working with your broker.

You can also roll a Roth IRA into a traditional IRA (but not vice versa). Keep in mind that you’ll pay income taxes on the amount you roll from a Roth into a traditional IRA, so consult a tax professional to make sure it’s a good idea.

If you have a 401(k), most employers won’t let you move money out of the account until after you leave your job. Most employers also won’t let you roll money from a previous employer’s 401(k) into your new one.

Once you leave a job, you can roll your 401(k) into an IRA by creating a new IRA or moving the money into an existing one. The process will depend on your 401(k) and IRA providers, so consult with them to find out about the specific process.

Keep in mind that there are strict IRS rules about how you conduct these rollovers. If you take money out of your 401(k) to put it into an IRA, you have only 60 days to complete the process. If you take too long, the IRS will consider it a withdrawal from your retirement account and assess any relevant taxes and penalties.

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IRAs and 401(k)s are both good accounts to use when you’re saving for retirement. If you can afford to, save as much as possible to take full advantage of the tax benefits available. However much you save, you should be happy that you’re planning ahead and building a nest egg for retirement.

Frequently asked questions (FAQs)

Can I contribute to both an IRA and a 401(k)?

Yes, it is possible to contribute to both an IRA and 401(k). They do not share a contribution limit.

What happens to my 401(k) if I change jobs?

If you change jobs, your previous 401(k) will remain where it is, though you can no longer contribute to it. You can choose to leave it as is or roll the balance into an IRA.

Are there income limits for contributing to a 401(k)?

There are no strict income limits for contributing to a 401(k), but there are special rules for highly-compensated employees. If you are a 5% owner of your business, make more than a set amount that changes each year ($155,000 in 2024) or are among the top 20% of earners at your company, you’re considered a highly-compensated employee. In that case, your contributions may be limited unless your employer follows specific rules surrounding enrollment and matching contributions when offering a 401(k).

How do I choose the right IRA or 401(k) plan?

Choosing between a traditional and Roth IRA or 401(k) can be tricky. In general, if your tax rate is higher now than it will be in retirement, a traditional account typically comes out ahead. If your tax rate is lower now than in retirement, a Roth account will be the better choice. Given that most people earn more during their careers than in retirement, which places them in a higher tax bracket, traditional accounts are usually more popular.