401(k) vs. IRA Differences: A Comprehensive Guide

The decision to contribute to a 401(k) or an IRA is understandably a difficult one, but the good news is that you’re able to contribute to both in the same year — even though you’re under no obligation to do so.

Here, we’ll look at the main considerations if you’re deciding between an IRA vs 401(k) for retirement savings.

What’s the difference between a 401(k) and an IRA?

Benefits of a 401(k) over an IRA

A 401(k), simply put, is a tax-advantaged retirement savings account that’s typically provided by your employer. Most — but not all plans — are tax-deferred in nature; what this means is that you’ll receive a tax deduction in the current year for the amount you contribute to the plan, and the money inside the plan will have a chance to grow over time. A 401(k) is a very common employer-provided vehicle that people use to save for retirement.

One significant benefit of a 401(k) is its healthy contribution limit. As an employee, you’re eligible to contribute up to $20,500 to your employer’s 401(k) plan in 2022. Should you contribute the maximum to your 401(k) in 2022, you’ll receive a tax deduction for $20,500, which will reduce your tax liability for the year. At the same time, you’ll have $20,500 in tax-deferred retirement investments that have an opportunity to grow over time.

Many 401(k) plans also come with matching contributions. Employers usually incentivize employees to contribute to their 401(k)s by offering an “employer match” up to a specified percentage of the employees’ salary. Commonly, you’ll find employers match between 3% and 6% of employee contributions to 401(k)s.

Example: Say you earn $100,000 in annual compensation as an employee. Also imagine that your employer matches up to 5% of your annual compensation when it comes to 401(k) plan contributions. If you contribute $5,000 to your 401(k), your employer will contribute another $5,000, for a total of $10,000 in your account to compound until retirement.

401(k)s also often come with employer-specific rules. Some of the more common ones:

401(k) vesting schedules

Many employers have rules surrounding 401(k) vesting. This means that you will likely need to stay at your employer for a certain number of years until your employer contributions “vest”, or “become fully yours”. If you leave before your account is “fully vested”, you may not have the chance to take your entire 401(k) account with you should you change jobs.

401(k) loans

Sometimes employers will allow you to take loans from your 401(k) plan, depending on the nature of your specific circumstances. This is truly employer-specific, so if you know how to access your 401(k) account, check your plan to see what options are available to you.

Roth 401(k) option

While most 401(k) plans are tax-deferred, some employers allow you to contribute after-tax money to a Roth 401(k). Rather than receive a tax deduction in the current year, by electing the Roth option, you voluntarily pay tax now in exchange for never paying tax again — even when you withdraw (or cash out your 401(k)) money in retirement.

Note: A Roth 401(k) might be a viable choice for someone who believes their tax rate during their working years is lower than it will be in their retirement years. It also might make sense for someone who believes taxes will rise generally over time, and sees the value in locking in a lower tax rate today.

Benefits of IRAs vs 401(k)s

An IRA — or, Individual Retirement Arrangement — is another type of retirement savings vehicle that many people pair with a 401(k). While the goal of an IRA is similar to a 401(k) — to cover costs in retirement — that’s about where the similarities end.

One of the main ways an IRA differs from a 401(k) is that it’s held entirely separate from your relationship with your employer: you need to actively open one on your own at an independent brokerage firm.

While there are many different types of IRAs, the two main types are the Traditional IRA and the Roth IRA. Contributions are limited to $6,000 in 2022 and $7,000 if you’re over 50.

Read on for more details about the two main IRA types:

Traditional IRA

A typically “pre-tax” IRA that is usually funded with “deductible” contributions (although this is not always the case, it is best to think of this account as a pre-tax account). This means that money contributed to a traditional IRA can look similar to a pre-tax 401(k) in that you’ll receive a tax deduction in the amount of your contribution, subject to a number of IRS considerations. Among them:

• Whether you’re covered by a retirement plan at work
• Whether your spouse is covered by a retirement plan at work
• Your tax filing status
• Your combined household income

Roth IRA

An “after-tax” IRA used to house money that’s already been taxed. In order to contribute directly to a Roth IRA, you must fall within the IRS income limits. The main benefit of a Roth IRA is that once you’ve contributed money, you’re able to invest it freely without any future tax burden. A fully funded Roth IRA is an achievable annual goal that will set you up quite nicely from both an investment and tax standpoint should you choose to take that path.

When should you choose an IRA vs. 401(k)?

While you can have active IRA and 401(k) accounts simultaneously, you may not have money available to fund both. If you need to make a financial decision about where to allocate your money, here’s when it makes sense to choose each retirement plan option.

Choose a 401(k) when you get an employer match

Failing to contribute enough to a 401(k) to get the employer match is like leaving free money on the table. Many employers offering a match will contribute up to a certain percentage. For example, your employer might match 100% of your contributions up to 3% of your income. In that case, it makes sense to contribute 3% to get the full match.

Choose an IRA when you don’t have a 401(k) with a match

Since 401(k)s can have fewer investment options and higher administrative fees, you’ll generally want to maximize IRA contributions before choosing to invest in a 401(k) that doesn’t get a match. With lower contribution limits for an IRA, you may be able to max out IRA contributions, then double back to add more money to your 401(k).

Be mindful of IRA contribution limits to ensure you’re contributing what’s allowed by law and taking advantage of tax deductions for traditional IRAs, if eligible.

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

You can have both a 401(k) and an IRA, and contribute to both in the same year. Recall that a 401(k) is an employer-sponsored retirement plan, and when you think 401(k), you should also be thinking of it in the context of your relationship with your employer. An IRA should be viewed as an independent account that you open on your own. Either way, you’re able to open both accounts and in the grand majority of cases that is a smart idea.

You’ll be able to contribute freely to a 401(k) and a Traditional IRA regardless of your income and filing status (although you will be restricted from direct Roth IRA contributions if you earn beyond the IRS limits). Contributing to both accounts is often not an issue; however, whether or not you receive a tax deduction for your IRA contribution will depend on your household income and a variety of other characteristics about your personal situation. Even if you don’t receive a deduction for your IRA contribution, you’re still able to contribute to the account.

Should I keep my 401(k) or roll over to an IRA?

Like the answer to most questions in personal finance, it depends. Many 401(k) plans come with higher-than-ideal fee structures and some of the plans may offer a limited investment menu. When comparing an IRA vs 401(k), IRAs tend to be more flexible and portable, and have access to a broader investment universe — though this is not always a meaningful benefit

Some 401(k)s might have unique investments that you’ll lose if you move the money to an IRA. 401(k)s also have maximal creditor protection, while IRAs are protected but not quite to the same level. While these are second and third-order concerns, they should be in your mind when deciding to move a 401(k) over to an IRA.

If you’ve left an employer to move on to a new job, you might also decide to move your old 401(k) into your new 401(k) plan. Depending on the quality of the new 401(k) plan, this is a smart idea in terms of consolidation. It’s generally not advisable to have previous 401(k) accounts scattered across different employer plans, as our recent white paper describes. If you’ve forgotten where an old 401(k) account is held, you can easily find it using your Social Security Number. It’s important to know how to check your 401(k) account balance.

No matter your decision, be sure to have thought about the pros and cons of moving money from a former employer’s 401(k) plan to a new (or existing!) IRA or your new 401(k) plan.