401(k) vs. IRA: Which Retirement Account Is Best for You?

You know saving money for retirement is crucial. You know your quality of life during retirement will depend on your retirement savings. But do you know which retirement account will best suit your needs? Should you pick a 401(k) or an IRA (aka individual retirement account)? 

There is no right or wrong answer. Truth is, the best retirement savings option for you will mostly depend on your financial situation and how you prefer to invest. 

To make a well-informed decision, you should know what each retirement plan offers and its pros and cons.

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

IRAs and 401(k) plans are both vehicles to save money for retirement, but there are key differences between them. 

A 401(k) is typically set up by your employer, but you can set up an IRA on your own without an employer’s involvement.

Employees with 401(k) plans typically make automatic contributions to their accounts from their paychecks. Many companies match all or a percentage of employee contributions – which is one of the most attractive features of a 401(k) plan. 

Many financial experts advise employees to take advantage of setting up a 401(k) and contributing at least the amount their employer will match. When you contribute less than your employer’s match, it’s like turning down free money.

IRAs, on the other hand, are usually not sponsored by employers. You can open an IRA account on your own with a bank, a life insurance or mutual fund company or a brokerage. An IRA is considered a great investment option for people who are self-employed or work for companies that don’t offer work-sponsored retirement plans.

401(k) Plans

A 401(k) is an employer-sponsored, tax-deferred retirement savings plan. Employees make automatic contributions to their plans from their paychecks. And in many cases, employers will match all or part of employee contributions.

You can contribute more money to a 401(k) than you can to an IRA. For 2022, the IRS is allowing employees to contribute a maximum of $20,500 to their 401(k) plans (the maximum contribution for IRAs is $6,000).^[1]

Because you’re making pretax contributions, your taxable income will be reduced by the amount you contribute. Let’s say you earn $60,000 a year. If you contributed $10,000 of your salary to your 401(k), your taxable income would be $50,000.

You should know that the investment options available with a 401(k) are more limited than the options you have with an IRA. With a 401(k), your employer or 401(k) plan sponsor will typically select mutual funds as investment options.  

Withdrawing funds from your 401(k)

Retirement money should only be for – you guessed it – retirement. But as we all know: life happens. 

It may have never been your intention or desire to withdraw funds from your 401(k) before retirement, but you may need the money to help you through an emergency, a difficult time or a significant life change. But the financial assist from your 401(k) will come at a cost. And you should know what happens if you dip into your 401(k) funds early. 

Any deductions you make before age 59½ will be taxed at your income rate, and you will face a 10% penalty fee.^[2]

Depending on your plan, you may be able to take out a loan or make a hardship withdrawal. When you take out a loan, you must pay it back, or you’ll face taxes and the 10% penalty fee. Your loan repayments are typically deducted from your paycheck.

You can make a hardship withdrawal for immediate, qualified financial emergencies. How much you take out will be limited to the amount you need to manage the emergency. 

IRAs

An IRA is another tax-deferred personal savings arrangement that lets you set money aside for retirement. The “I” in IRA stands for “individual.” Individuals typically open IRAs – not employers – though there are some exceptions we’ll touch on later. Anyone can open and contribute to an IRA as long as they earn an income.

Types of IRAs

The two most common IRAs are the:

• Traditional IRA: Your contributions are usually tax-deductible and are not taxed until you withdraw funds.
• Roth IRA: Your contributions are not tax deductible, but withdrawals are tax-free.

Like a 401(k), if you withdraw from your IRA before age 59½, you’ll likely pay income tax and a 10% withdrawal penalty fee.^[3]

Another drawback is that the contribution limit for an IRA is much lower than it is for a 401(k). The max contribution you can make to a traditional or Roth IRA in a year is $6,000 ($7,000 if you’re 50 or older).^[4]

But what an IRA lacks in max contribution amounts, it makes up for with investment options. IRAs offer more investment options than 401(k) plans. With an IRA account, you can invest in a nearly unlimited pool of funds, including stocks, bonds, CDs and real estate.  

SEP and SIMPLE IRAs

Remember those exceptions we mentioned earlier? Well, there are two IRAs employers can offer: SEP and SIMPLE IRAs. They work a lot like 401(k) plans, but there are key differences, including their contribution limits. 

• SEP IRA: A business of any size (including self-employed individuals) can open a simplified employee pension (SEP) plan. A SEP is a traditional IRA set up by employers for their employees. Only the employer contributes to the SEP IRA, and the contribution maximum is higher than it is for a traditional IRA. For 2022, your employer can contribute up to 25% of your salary, but your contribution can’t be higher than $61,000.^[5]

• SIMPLE IRA: Your employer can contribute to a savings incentive match plan for employees (SIMPLE). SIMPLE plans are only available to small businesses with 100 employees or less. Your employer is required to either match up to 3% of your salary or provide a 2% nonelective contribution – which means your employer will contribute 2% of your salary whether you contribute to the plan or not.^[6]   

Which One Is Best for You? 

If you’re still on the fence about a 401(k) or an IRA, think about what’s available with your current employment situation. And then think about your investment preferences. These two factors can help you come up with an answer. 

And, by the way, no one is stopping you from deciding that you don’t want to choose between the two. A 401(k) can co-exist with an IRA in your investment portfolio. 

But if you can only choose one, opening a 401(k) is probably the best way to go – especially if your company matches contributions.