Understanding the Difference Between a 401(k) and an IRA
When planning for retirement, two of the most popular options to consider are the 401(k) and the Individual Retirement Account (IRA). Both provide valuable tax advantages, but they differ in key ways regarding how they operate, the investment opportunities they offer, and how they fit into your overall retirement plan. Below, we’ll dive into the differences between the two, the benefits they offer, and whether it makes sense to have both.
What is a 401(k)?
A 401(k) is an employer-sponsored retirement savings plan that allows employees to contribute a portion of their income, often with pre-tax dollars. Contributions grow tax-deferred, meaning you won't pay taxes on the money until you withdraw it during retirement. Many employers also offer matching contributions, which can significantly boost your savings.
401(k) plans typically offer a limited range of investment options, usually including mutual funds, stocks, and bonds. Withdrawals can begin at age 59½, with mandatory withdrawals (known as Required Minimum Distributions, or RMDs) starting at age 73. If you withdraw money before 59½, you may face a 10% early withdrawal penalty on top of income taxes.
Note: be aware that employer contributions, are typically subject to a vesting schedule.
What is an IRA?
An IRA is a retirement account you can open on your own, independent of your employer. There are two primary types of IRAs: Traditional and Roth.
Traditional IRA: Contributions may be tax-deductible, and the money grows tax-deferred until you withdraw it in retirement. Like a 401(k), withdrawals before age 59½ can trigger penalties.
Roth IRA: Contributions are made with after-tax dollars, but qualified withdrawals are tax-free, provided you meet certain requirements.
With an IRA, you generally have more investment options than a 401(k), as you're not restricted to what your employer offers. You can invest in stocks, bonds, mutual funds, ETFs, and even real estate in some cases. The contribution limits are lower than those for a 401(k), however, and eligibility for tax benefits may phase out at higher income levels.
Key Differences Between a 401(k) and an IRA
Employer Sponsorship: A 401(k) is offered through your employer, while an IRA is opened individually.
Contribution Limits: In 2024, the contribution limit for a 401(k) is $23,000, whereas for an IRA, it’s $7,000 ($8,000 for those aged 50 or older).
Investment Options: IRAs generally offer more flexibility in terms of investment choices compared to a 401(k).
Tax Benefits: Both plans offer tax-deferred growth, but the timing of your tax benefits varies between a Traditional IRA, Roth IRA, and 401(k).
Should You Have Both?
It can be beneficial to have both a 401(k) and an IRA. If your employer offers a match on your 401(k) contributions, it’s often wise to take advantage of that first. Once you've maxed out your 401(k) contributions or if you want additional investment flexibility, opening an IRA—especially a Roth IRA—can provide additional tax diversification in retirement.
