As a retirement saver, you likely know about common tax-advantaged accounts like IRAs and 401(k)s. But understanding the nuances of how these accounts differ is key to creating an optimal savings strategy.
This guide examines everything you need to know about IRAs and 401(k)s when planning for your nest egg.
What is a 401(k)?
A 401(k) is an employer-sponsored retirement savings account. Contributions come out of your paycheck before taxes, lowering your taxable income now while letting savings grow tax-deferred for later.
Many employers offer matching contributions up to a percentage of your 401(k) contributions as an extra incentive to participate.
What is an IRA?
An individual retirement account (IRA) is a personal tax-advantaged account you open yourself through a bank or brokerage.
There are a few types of IRAs like Traditional, Roth, SIMPLE and SEP IRAs. Each have different rules around taxes and access to funds.
Key Aspects to Compare
When weighing IRAs vs 401(k)s for your situation, consider these key factors:
- Contribution limits
- Tax treatment
- Investment options
- Accessibility
- Required minimum distributions
Reviewing these points of difference helps determine the better account for your goals.
Contribution Limits Differ Greatly
One major difference comes down to IRA vs 401(k) contribution limits per federal laws.
For 2023, the limits are:
- 401(k): $22,500 ($30,000 over 50)
- IRA: $6,500 ($7,500 over 50)
So you can potentially save far more money for retirement annually in a 401(k) account.
Tax Advantages Vary By Account Type
Both accounts provide valuable tax perks, but they work differently.
401(k) contributions lower your current taxable income. You pay income taxes on withdrawals later in retirement.
IRAs have upfront and backend tax differences depending on if you choose a Traditional or Roth IRA. It pays to understand the implications.
Investment Flexibility Favors IRAs
IRAs allow investing in nearly any stock, fund, bond, CD, etc which leads to greater portfolio control.
401(k) options are usually limited to preset allocation funds picked by your employer or plan provider. The convenience factor is higher with a 401(k) however.
When Can You Tap Into Funds?
Accessing funds early from either account leads to taxes and penalties in most cases.
However, IRAs typically offer earlier hardship withdrawal flexibility than 401(k) accounts in certain situations.
But best practice is leaving money alone until retirement when possible.
Required Minimum Distribution Rules
At age 73, mandatory annual required minimum distributions (RMDs) from your accounts go into effect for most common types of IRAs and 401(k)s.
Failure to take RMDs results in a hefty 50% penalty tax on the amount not withdrawn as required!
Which is Best for Small Businesses: SIMPLE IRA vs 401(k)?
For small companies, SIMPLE IRAs are usually preferable over 401(k) plans due to less administrative overhead and lower costs.
The SAVE ROTH OR 401K tradeoff is employers must either match employee contributions up to 3% of income, or make compulsory contributions equaling 2% per eligible employee.
So smaller businesses can usually handle SIMPLE IRA expenses more easily than a standard 401(k).
Roll Over 401(k) to an IRA Upon Job Change
When you leave an employer where you have a 401(k), rolling it over into a Rollover IRA account lets you maintain tax-deferred status while gaining access to more investment choices for continued growth.
This prevents automatic forced distributions or early withdrawal penalties. It pays to connect with a financial advisor to handle rollovers properly.
Can You Have Both a 401(k) and IRA?
Yes absolutely! If your income allows, funding both types of accounts annually is a prudent saving strategy.
Max out match-eligible 401(k) contributions first, then aim to fully fund your IRA as well each year. This diversifies your tax-advantaged money across more than one account.
Use Comparison Tables to Evaluate Options
Key Aspects. | 401(k) | Traditional IRA | Roth IRA |
| Contribution Limit | $22,500 in 2023 ($30,000 over 50) | $6,500 in 2023 ($7,500 over 50) | $6,500 in 2023 ($7,500 over 50 |
| Tax Treatment | Pretax contributions Taxed withdrawals | Potentially tax deductible contributions Taxed withdrawals | After-tax contributions Tax-free withdrawals |
| Investment Options | Limited fund selection | Nearly unlimited choices | Nearly unlimited choices |
| Employer Matching | Frequently Yes | No | No |
| Early Withdrawal Penalties | Yes, with some exceptions | Yes, with some exceptions | Yes, with some exceptions |
Conclusion
When saving for retirement, IRAs and 401(k)s both provide valuable tax advantages that help grow your nest egg over the long run. 401(k)s offer higher contribution room each year, convenient payroll deductions, and potentially employer matching funds. IRAs provide more flexibility around investments, withdrawals, and opening your account at any financial institution.
Understanding the key differences in contribution limits, tax treatment, account access, and more allows you to develop an optimal strategy. Many retirement savers choose to utilize both account types – maximizing 401(k) employer matches first, then fully funding their IRA annually. Along with projecting your income needs in retirement, comparing IRA and 401(k) pros and cons today can set you up for long-term saving success.
The differences between these two common tax-advantaged accounts may be nuanced but are important to grasp. Educating yourself on how IRAs and 401(k)s work can empower you to make savvy decisions as part of your overall financial planning.
FAQs
Can I have both a 401(k) and an IRA?
Yes, you can contribute to both a 401(k) and an IRA in the same year. Many retirement savers fund a 401(k) up to the employer match, then max out an IRA, before returning to add more to the 401(k).
What’s the benefit of a 401(k) over an IRA?
The main advantages of a 401(k) are higher contribution limits, potential employer matching contributions, and automated payroll deductions for funding the account.
When is an IRA better than a 401(k)?
IRAs provide more flexibility in investment choices, the ability to deduct contributions depending on income, tax-free growth and withdrawals with a Roth IRA, and control over opening your account anywhere you want.
Can I roll over my 401(k) to an IRA?
Yes, you can complete a direct rollover of 401(k) funds into a Rollover IRA when leaving an employer. This preserves the tax-advantaged status while giving you more investment control.
What are SIMPLE and SEP IRAs?
SIMPLE and SEP IRAs are types of IRS-approved retirement accounts meant for small businesses. They offer employees tax perks but involve fewer administrative requirements compared to full 401(k) plans.
