What Is The Difference Between A 401K And An IRA?
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It can be confusing to differentiate between all the different types of retirement plans offered. The acronyms are confusing, and there are different rules for each plan. We're here to distill it for you!
In essence, the difference between IRAs and 401(k)s is the party establishing the plan.
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What Is a 401K?
A 401(k) plan must be established by an employer. In a 401(k), employees have the option to contribute a portion of their salaries to the plan. With an employer match, the employer may also contribute to the employee's account by "matching" his or her 401(k) contribution.
If you are employed, you are most likely saving for retirement through a separate retirement savings vehicle called a 401(k) plan. A 401(k) is a retirement account sponsored by your employer. It differs from an IRA which you may open on your own.
401(K) Type Overview
Just like an IRA, you can usually choose a traditional (pre-tax) or a Roth (post-tax) option, if your employer offers the Roth 401(k) option. For most 401(k) plans, you are contributing to a traditional 401(k). Contributions to a traditional 401(k) are made before you pay taxes on it. So, your taxable income becomes lower.
In Roth 401(k), you have already paid income tax for the contributions you made. In return, distributions from your 401(k) become tax-free when you retire.
401(k) Contribution Maximum
Employee contributions to traditional or Roth 401(k)s are subject to a $22,500 annual contribution limit in 2023. This limit typically goes up every year or every other year, adjusted for inflation. Employees aged 50 and up who want to "catch up," can contribute up to $30,000. Your employer may "match" part of your contributions. That is not included in the $22,500 max.
401K Pros and Cons
- Higher contribution limits - In 2023, you can contribute up to $20,500 if you're under 50 and up to $27,500 if you're over 50
- Tax advantages - You can invest with pre-tax income, and your earnings grow tax-deferred until you withdraw funds in retirement
- Employer contributions - Some employers match a portion of your contributions; it's usually a percentage of your salary
- Loans may be possible - Some employers allow you to borrow from your 401K for emergencies
- Limited investment options - You may only invest in the investment options your employer provides
- High fees - Many 401K plans have high fees that reduce your overall earnings
- Early withdrawal penalty - If you withdraw funds before age 59 1/2, you'll pay a 10% penalty plus applicable taxes
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What Is an IRA?
On the other hand, an IRA is an individual retirement account which is not tied to your employer. You can set up an IRA through an IRA provider and make a lump sum or periodic contributions. You may also rollover 401(k) contributions to an IRA account.
Roth IRA vs Traditional IRA
IRAs can either be a Traditional IRA or a Roth IRA. Understanding the difference is important because one may be better suited to you than the other.
In a traditional IRA, your contributions are pre-tax (or tax-deductible) for people at lower income levels. You avoid paying taxes for contributions when you put them in, but your withdrawals during retirement are taxable.
For people at higher income levels, traditional IRAs do not offer any tax advantage. In 2022, if your modified adjusted gross income is more than $68,000 but less than $78,000 (single) or more than $109,000 but less than $129,000 (married couple) or less than $10,000 (married filing separately), you can only take a partial tax deduction for contributions to a traditional IRA.
Above the upper limit, your contributions will no longer be deductible.
In a Roth IRA, contributions are taxable (you put in after-tax dollars from your paycheck after taxes have been taken out), but they can grow tax-free. Some people in lower income brackets can get a tax credit for contributing to a Roth IRA, but for most people using Roth IRAs, contributions are post-tax.
Since you already paid income taxes on the contributions to Roth IRAs. Qualified distributions, including the fund's earnings, are exempt from taxes when you reach the age of 59½.
IRA Annual Contribution Limits
In 2023, the combined contribution limit for IRAs (traditional IRA and Roth IRA) is $6,500 ($7,500 if you are 50 and up). This limit usually sees an increase every year because it is adjusted for inflation.
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IRA Pros and Cons
- Tax benefits - Whether you invest in a Roth or traditional IRA, you get tax benefits either during retirement (Roth IRA) or the year you contribute (traditional IRA)
- Control over the investment options - You can invest your IRA funds in any investment you choose
- No income limits - If you open a traditional IRA, there aren't any income limits; anyone can open one if they have income or if they have a working spouse
- No permission necessary - You don't need permission to withdraw funds if you have an emergency, but you might pay an early withdrawal penalty
- Early withdrawal penalty - If you withdraw retirement funds before age 59 1/2, you'll pay a 10% penalty plus applicable taxes
- Lower annual contribution limits - IRAs have much lower annual contribution limits of $6,500 if under 50 and $7,500 if over 50
- Required minimum distributions - If you own a traditional IRA, you may be subject to required minimum distributions at age 70 1/2
IRA and 401k Alternatives
If you maxed out your retirement plans, and want other investment options to ensure you have enough money for retirement, here are some common alternatives:
- Real estate investments
- Mutual funds
- Stocks and bonds
If you don't have a tax-advantaged retirement account, you'll pay taxes on the income earned when you sell the assets. But, if you work with your tax advisor, you can minimize your tax liabilities while maximizing your capital gains.
Related Article | Can I Roll an RRSP into an IRA?
IRA vs 401K FAQs
How Much Should I Contribute to My 401K or IRA?
Ideally, you should contribute 15% of your income to your retirement accounts. Of course, that might not always be possible, but aim for that threshold as you build your budget and plan for your future to reach your retirement goals.
Can You Have a Roth IRA and a 401K?
Yes, you can contribute to a Roth IRA and 401K at the same time. Consider maximizing the contributions your employer will match in your 401K and then invest in your Roth IRA. First, however, be sure you are eligible for a Roth IRA and don't make too much money.
How Much Should I Have In My 401K or IRA by Retirement?
There are many rules of thumb regarding how much you should have in your 401K or IRA by retirement, but overall, you should have ten times your annual salary for a comfortable retirement.
Does an IRA Earn Interest?
IRAs or Individual Retirement Accounts don't earn interest, but depending on where you invest your money, they could. For example, if you invest funds in a CD or high-yield savings account within your IRA, the money will earn interest.
Which One Is Better- 401K or IRA?
A 401K has more benefits, including employer contributions and higher contribution limits, but an IRA is a good option, especially as an addition to your 401K. When opening an IRA, consider whether you should open a traditional or Roth IRA and if you make more than the income limits for a Roth IRA (If you do, you can consider a backdoor Roth IRA).
What Is the Difference Between a 401K and an IRA - The Bottom Line
A 401K and IRA are both great vehicles for retirement. They provide tax advantages and help you reach your retirement goals. You can set aside before and after-tax dollars to help you reach your retirement goals, but you should always, at a minimum, meet your employer match to get the employer contributions.