IRA vs. 401(k): Which One is Better?

ByG. Dautovic
March 14, 2022

Are you trying to save for retirement? If so, you might be wondering whether an IRA or a 401(k) is the right option for you. In this article, we will compare and contrast these two accounts and help you decide which is the best fit for your needs. Both IRAs and 401(k)s have their pros and cons, but in the end, it comes down to personal preference and circumstances. Let’s get right into it, shall we?

What is an IRA?

Before we get to the bottom of IRA vs. 401(k), let's first go through some basics and take a look at what an IRA actually is. An IRA, or Individual Retirement Account, is a personal savings account that offers tax benefits to encourage saving for retirement. Anyone with earned income can contribute to an IRA up to a certain limit. However,  there are a few restrictions: you can’t contribute if you’re covered by a company retirement plan, and the contributions must stop once you reach the age of 72.

Types of IRAs

There are two types of IRAs: Traditional and Roth. Let’s see how they work so we can make an informed comparison between Roth IRA vs. Traditional IRA vs. 401(k) accounts.

  • With a Traditional IRA, your contributions may be tax-deductible (depending on your income level), but you’ll have to pay taxes when you pull the money out later. The account balance is best left alone until you turn 59 ½, or you'll have to pay a 10% early distribution penalty. When you later make a withdrawal in retirement, the money is taxed as ordinary income. After the age of 72, you are no longer allowed to contribute to a Traditional IRA, and you will be forced to take required minimum distributions on a yearly basis.
  • A Roth IRA is the opposite of a Traditional IRA. Your contributions are not tax-deductible, but all subsequent earnings and withdrawals are tax-free. One of the main differences when comparing a Traditional IRA vs. a Roth IRA account is that Roth IRA contributions have no age limit, so you can continue contributing even after 72 or pass the money onto your heirs. Another major benefit of a Roth IRA is that there is no required minimum distribution.

What is a 401(k)?

Now that we know what an IRA is let’s move on to 401(k)s. A 401(k) is an employer-sponsored retirement savings plan. Employees can choose to have a portion of their paycheck withheld and deposited into their 401(k) accounts. There are contribution limits for a 401(k), just like with an IRA account.

However,  your employer can match your contributions up to a certain percentage, increasing the total amount. This means that you will typically earn less for retirement with an IRA account vs. a 401(k).

Types of 401(k)s

There are two types of 401(k)s: Traditional and Roth, and here’s how they work:

  •  With a Traditional 401(k), your contributions are tax-deferred, and you don’t have to pay taxes on withdrawals until retirement. The money in the account can grow until withdrawn in retirement, but once you decide to withdraw it, it will be taxed at the usual income rates. 
  • With a Roth 401(k), your employee contributions are made with after-tax dollars, but your earnings grow tax-free, and you don’t have to pay taxes on withdrawals in retirement. After turning 72, you are no longer allowed to contribute to a Roth 401(k), and you have to take the required minimum distributions (RMDs).

The Difference Between IRA and 401(k)

Now that we know a little more about IRAs and 401(k)s, let's take a look at the main differences between these two types of accounts:

  • A 401(k) is an employer-sponsored plan, while an IRA is a personal savings account.
  • When comparing  401(k) vs. IRA, keep in mind that with the former, employees can choose to have a portion of their paycheck withheld and deposited into their account. With an IRA account, you have to make the contributions yourself.
  • A 401(k) has a higher contribution limit than an IRA.
  • With a 401(k), your employer may match your contributions up to a certain percentage, while IRA contributions are not matched by employers.
  • You are not allowed to contribute to a Roth 401(k) after turning 72. With a Roth IRA, there is no age limit for contributions.

Having gone over the main differences between IRA vs. 401(k), you might be wondering which account is right for you. The answer ultimately comes down to personal preference. If you’re looking for an employer-sponsored retirement savings plan, a 401(k) is probably your best bet. If you're looking for a personal savings account with tax benefits, an IRA might be a better choice for you.

Who Should Use an IRA?

An IRA is perfect for anyone who wants to save for retirement but doesn't have access to a company-sponsored retirement account, which is one of the main benefits of IRA vs. 401(k).

If you're covered by a company retirement plan, you may not be able to contribute to an IRA (unless your income falls below a certain limit). You can still contribute to a 401(k). However, all contributions must stop once you reach the age of 72.

Qualifying for an IRA

There are a few things you need to know in order to qualify for an IRA:

  • You must have earned income from a job or self-employment. Investment income, pensions, and annuities do not count.
  • If you’re covered by a company retirement plan, your contributions to an IRA may be limited (unless your income falls below a certain limit).
  • You must be under the age of 72 to contribute to a Traditional IRA or any of the 401(k) accounts. If you compare a Traditional IRA vs. Roth IRA vs. a 401(k) account only the Roth IRA allows contributions even after you reach the age of 72.

IRA Contribution Limits

There are two types of IRA contribution limits: the Annual Contribution Limit and the Age-Based Contribution Limit.

  • The Annual Contribution Limit is the maximum amount you’re allowed to contribute to an IRA in a year. In 2022, this limit is $6,000 for those under the age of fifty and $7,000 for those who are fifty or older.
  • The Age-Based Contribution Limit is the maximum amount you're allowed to contribute to an IRA once you turn 72. At this point, you are no longer allowed to make contributions to a traditional IRA account.

Pros and Cons of IRA Plans

Although there are many pros of using IRA plans, there are also a few downsides. Here's a list of the main advantages and disadvantages to consider:

Pros:

  • It is accessible and easy to set up.
  • You can contribute to an IRA even if you’re not covered by a company retirement plan.
  • There are no age limitations for contributions.
  • You can choose to have your contributions withheld from your paycheck.

Cons:

  • The contribution limit is lower than the 401(k) contribution limit.
  • Your employer does not match your contributions.
  • Qualifying for an IRA can be difficult if you’re covered by a company retirement plan, which is one of the major cons of the IRA accounts.
  • You are not allowed to contribute to a Traditional IRA after turning 72.

Who Should Use a 401(k)?

A 401(k) is perfect for anyone who wants to save for retirement and get matching contributions from their employer. Any employee that is covered by a company retirement plan can still contribute to a 401(k) until they reach the age of 72. 401(k) plans are also viable for small business owners and self-employed individuals but remember that if you’re the boss, you’ll be the one paying your own contributions, much like with an IRA plan.

401(k) Contribution Limits

In 2021, employees could contribute up to $19,500 to their 401(k) accounts. In 2022, things have changed a bit, and they can now contribute up to $20,500.  And those who are 50 or older can contribute an additional $6,500.

Pros and Cons of 401(k) Plans

As with IRA accounts, there are multiple pros of using 401(k) plans, but also some drawbacks to consider. Let’s go through both:

Pros:

  • Your employer may match your contributions.
  • The contribution limit is higher than the IRA contribution limit.
  • You can contribute to a 401(k) even if you’re not covered by a company retirement plan.
  • Automatic payroll deductions.

Cons:

  • You are not allowed to contribute to a 401(k) after the age of 72.
  • Contributions are made with pre-tax dollars, which reduces your taxable income for the year.
  • You have a limited investment selection.
  • As with traditional IRA accounts, If you take a distribution from a standard 401(k), you will have to pay taxes on it.

Final Thoughts

Whether you wish to start your retirement planning or just want to change your current retirement savings strategy, it's important you understand the difference between IRA and 401(k) accounts. So, if you’re wondering which is better, an IRA or a 401(k), the answer is that it depends on your situation.

Both the IRA and 401(k) plans have their pros and cons, and it's important to understand how they work before you decide which one is right for you. We hope our guide has helped you do just that!

And if you’re still not sure how to make that decision, we suggest you consult with a financial advisor, who can give you even more detailed tips about these popular types of savings accounts. 

FAQ

What happens to my IRA if the stock market crashes?

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Your IRA will be affected by the stock market just like any other investment, and although there are many advantages of IRA accounts, you should be aware that they are not risk-free. It's important to remember that you don't have to (and shouldn’t) keep all of your money in stocks. You can choose to invest in a variety of different things, including bonds, real estate, and mutual funds. This will help reduce the risk if the stock market does take a dive at some point.

At what age should you open an IRA?

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You can open an IRA at any age. However, you will only be able to contribute to it if you have earned some income beforehand. This means that if you’re retired, you won’t be able to make any new contributions to your IRA. People usually start thinking about opening an IRA in their prime working years, between the ages of 25 and 50. Many of them don't know the distinction between IRA vs. 401(k), which is why it’s essential to educate yourself on the topic.

What are the three sources of retirement income?

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The three main sources of retirement income are pensions, social security, and personal savings. Pensions used to be the primary way people saved for retirement, but they are becoming less common as more and more companies move away from them. Social security is a government program that provides monthly payments to retirees. And finally, personal savings come from money you’ve saved up with 401(k), IRA, and other investment accounts.

About author

I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.

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