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Updated on Wednesday, April 29, 2020
An IRA, or individual retirement account, is a self-managed account that anyone can open, while a 401(k) is only available through your employer if they offer one. The two types of retirement plans also have different contribution limits, investment options and associated costs.
It’s important to understand these differences to maximize your retirement savings, though you don’t necessarily have to choose one plan over the other — it can be a good idea to open one of each to reach your retirement goals.
- The difference between IRA and 401(k)
- The similarities between IRA and 401(k)
- 401(k) vs IRA: Which should you choose?
The difference between IRA and 401(k)
|Annual contribution limit||$6,000 ($7,000 if you’re 50 or older)||$19,500 ($26,000 if you’re 50 or older)|
|Investment options||Wide range||Limited choices|
|Costs||Generally lower||Multiple fees|
|Employer match available||No||Yes|
|Eligible for payroll deduction||No||Yes|
One major difference between an IRA versus a 401(k) is that anyone can open an IRA on their own. As long as you — or your spouse, if you file a joint tax return — have taxable compensation, you’re eligible for an IRA.
With a 401(k) plan, you’re only eligible if you’re employed and your company offers one. Otherwise, you can’t open an account or make contributions. If you leave the company or lose your job, you can no longer contribute to the 401(k).
Compared with IRAs, 401(k) plans have much higher contribution limits. With an IRA, you can only contribute up to $6,000 per year. With a 401(k), you can contribute up to $19,500 per year.
If you’re 50 years or older, you can make catch-up contributions to help you save more for retirement that are above the regular contribution limits. With an IRA, the total annual contribution limit for people 50 and older is $7,000. With a 401(k), you can contribute an additional $6,500 on top of the $19,500 maximum contribution in 2021.
Your 401(k) plan will likely have administrative fees, investment-related expenses and distribution fees, while IRAs may have lower expenses. With a 401(k), you don’t have the luxury of shopping around; you only have the option your employer offers. But with an IRA, you can compare different brokers and choose a company that offers lower fees and transaction costs to save money.
With a 401(k) account, you can only choose from a preselected list of investment options. Your options may include a mix of index funds and mutual funds.
IRA plans tend to have more investment choices, including mutual funds, exchange-traded funds (ETFs) and bonds.
IRA accounts aren’t eligible for employer-matching contributions like 401(k) accounts.
With employer-matching contributions, your employer will match a portion of your 401(k) contributions, up to a percentage of your salary. For example, an employer might match 100% of your contributions, up to 3% of your salary. If you made $40,000 per year and contributed $1,200 to your 401(k) — 3% of your salary — your employer would match the entirety of your contribution, adding another $1,200 to your 401(k).
This is a significant perk that can effectively double your retirement contributions, and it’s an important part of your compensation package. Employer-match contributions aren’t subject to the same contribution limits that you have to follow, so the employer match can help you save even more for retirement. The combined maximum contribution limit for your contributions and your employer’s contributions is $57,000 or 100% of your salary, whichever is less, excluding catchup contributions.
Your 401(k) contributions can normally be deducted directly from your paycheck through payroll. But with an IRA, you’ll have to set up contributions on your own.
With a 401(k), your contributions to your account are made with pretax dollars. Your investments can grow tax-deferred until you start taking distributions when you reach retirement age.
By contrast, your contributions to an IRA may be tax-deductible. If neither you or your spouse are covered by a retirement plan through your employer, you can deduct the total amount of your IRA contributions, as long as your modified adjusted gross income falls below a certain threshold. If you or your spouse are covered, you may be able to deduct just a portion of your contributions. Your modified adjusted gross income will also influence your deduction eligibility.
If you need money to pay for a home repair or other major expense, you typically can’t access the funds in your IRA before you reach age 59½ without incurring a 10% early withdrawal penalty. But with your 401(k), you have the option to take out a loan from your account. You can borrow up to 50% of your vested balance, up to a maximum of $50,000. Typically, a 401(k) loan must be repaid within five years, with interest.
Keep in mind that if you lose your job or quit, you might have to repay your loan, in full, right away. If you can’t repay your loan, you’ll enter into default, and you’ll owe taxes on the loan and a 10% early withdrawal penalty.
The similarities between IRA and 401(k)
When people talk about setting aside money for the future, they often mention both 401(k) and IRA plans. That’s because both account types are tax-advantaged retirement savings accounts. For many, it’s a good idea to open one of each rather than depending on just one or the other to reach your retirement goals.
With a 401(k), your elective salary deferrals — how much of your paycheck you contribute to your 401(k) — are excluded from your taxable income, reducing your tax bill. You pay taxes on the contributions and earnings only when you start taking distributions from the account.
With a Traditional IRA — one of the types of IRAs available — you can deduct some of your contributions to your plan, also reducing your taxable income. But unlike 401(k) plans, how much you can deduct is dependent upon your income and whether or not your employer or your spouse’s employer offers a retirement plan.
Available as Roth accounts
When evaluating your options, keep in mind that there are Roth versions of both 401(k) and IRA accounts. With both a Roth IRA and a Roth 401(k), your contributions are made with after-tax dollars, and you can make tax-free withdrawals once you retire. This can be beneficial if you believe your tax rate is lower now than it will be when you retire.
Roth IRAs and Roth 401(k) plans have the same contribution limits as their respective non-Roth counterparts. While there are income restrictions on Roth IRA plans, Roth 401(k)s do not have income restrictions, meaning you can contribute up to the annual maximum regardless of how much money you make.
Hardship withdrawals offered
If you need money to cover a major expense, you can only take out a loan from a 401(k); an IRA doesn’t offer that option. However, if you’re experiencing a substantial financial hardship, both 401(k) and IRA plans offer hardship withdrawals.
You can take out a hardship withdrawal from your 401(k) if you have a serious and immediate financial need and can’t cover the expense with money from another source. You can only take out enough money to pay for the immediate need.
If you have an IRA, you can take out a hardship withdrawal in the following circumstances:
- You have medical expenses that exceed 7.50% of your adjusted gross income
- You’ve become totally and permanently disabled
- You’re a military reservist called to active duty
- You’re taking distributions after a qualified disaster
401(k) vs. IRA: Which should you choose?
If you’re still not sure whether you should open a 401(k) account or an IRA, here are a few common scenarios to consider in figuring out the best option for you:
- If your employer offers a 401(k) plan and matches your contributions: If your employer will match your contributions, start with a 401(k) plan. Make sure you open an account and contribute enough to it to get the full match — that’s money you’d otherwise lose. If at all possible, also open an IRA and make contributions to that as well. If you can afford to do so, maxing out both accounts will help set you up for a secure retirement.
- If your employer has a 401(k) but doesn’t match contributions: If your employer won’t match your contributions, start by opening an IRA or a Roth IRA account first since the IRA may have fewer fees and more investment options. Contribute up to the IRA’s annual maximum into the account. If you have money left over after maxing out the IRA, make contributions to your 401(k).
- If you’re young and have a 401(k) account: In this case, consider opening a Roth IRA. You can lower your taxable income with your 401(k) contributions, and contribute to the Roth with after-tax dollars. Once you retire, you’ll be able to take withdrawals from your Roth IRA tax-free. When your income bracket is lower and you can qualify for a Roth IRA, it’s smart to take advantage.
- If you’re self-employed: If you’re self-employed, another option is to open a SEP IRA. With a SEP IRA, you can contribute up to $58,000 per year as of 2021. This article provides more information about SEP IRAs and how to open an account.
For most people, only saving in one retirement account won’t be enough to prepare you for the future. The annual contribution limits mean you won’t have enough money tucked away once you retire if you only save in one account. When possible, open up both a 401(k) and IRA account to maximize your savings and allow your nest egg to grow.
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