IRA vs 401(k): Choosing the Right One For You

When it comes to retirement accounts, there are two major players — the IRA vs 401(k). One isn’t necessarily better or worse than the other. They’re just two different ways to grow your wealth and save for your future. The right one for you will depend on your employment status, investment preferences, and financial health. 

Here’s everything you need to know so you can figure out which one feels like the best fit. Spoiler: you might choose both.

401(k) plans

A 401(k) is an employer-sponsored retirement plan, and it’s pretty common. There are two main types: a traditional 401(k) and a Roth 401(k). They’re structured a little differently, but both can help you build your nest egg while snagging tax advantages. Investment options vary depending on the plan administrator but may include individual stocks, bonds and other securities.

What is a 401(k)?

Both a traditional 401(k) and Roth 401(k) are designed to make it easier for workers to save for retirement. Here’s a closer look at how these investment accounts work.

Traditional 401(k)

You fund this type of retirement account with pre-tax dollars. That means it goes straight into your 401(k), usually through automatic payroll deductions. These contributions are tax deductible. This means that they reduce your taxable income during your working years. 401(k) contributions also grow on a tax-deferred basis. You won’t be taxed until you withdraw funds during retirement. At that point, you’ll be taxed at your ordinary income tax rate.

Roth 401(k)

Unlike a traditional 401(k), a Roth account is funded with after-tax dollars. If you’re at least 59½ and have had the account for five years or more, you can tap your contributions and earnings tax-free and with no penalty. That’s good news for folks who expect to be in a higher tax bracket when they retire.

401(k) contribution limits

Each year, the IRS sets a limit on how much you can contribute to tax-advantaged retirement accounts, and that includes 401(k) plans. For folks who are 50 and over, they can contribute an extra amount, also known as catch up contributions.

If your employer chooses to fund your 401(k) too, their contributions will not count toward your limit. With that said, there's also a limit on total contributions from both you and your employer, set each year according to the IRS. 

401(k) matching

On top of the money you put in, your employer might also match some or all of your contributions, called a 401(k) match. It’s an employee perk that can accelerate your retirement savings. Remember that 401(k)s are investment accounts that have the opportunity to earn compound returns — which is basically returns on returns. The more money you have in your 401(k), the more likely it is to benefit from the potential of compounding over time.  

Try our compound interest calculator to see for yourself!

401(k) withdrawals

Income taxes apply to traditional 401(k) distributions, but Roth 401(k)s are different. Since they’re funded with after-tax dollars, distributions are tax-free as long as you’re 59 ½ or older and have had the account for at least five years. Withdrawing funds from a traditional or Roth 401(k) before age 59 ½ will likely trigger a 10% penalty.

It's also important to understand required minimum distributions (RMDs). When you turn 73, you must begin taking RMDs from all employer-sponsored retirement plans. IRS rules will determine your withdrawal amount. 

IRAs

Now let’s talk about the IRA vs 401(k). There are some key differences, but both can set the stage for tax-efficient retirement saving.  

What is an IRA?

Unlike 401(k)s, IRAs are not employer-sponsored accounts. You can open one yourself, usually through a broker, and then select your investments. That can include stocks, bonds, mutual funds, index funds, and exchange-traded funds (ETFs). One benefit of an IRA is that funds typically grow tax-free. That means you won’t pay taxes on gains and dividends until you withdraw money, which sets it apart from a regular brokerage account.

Traditional vs. Roth IRA

In some ways, a traditional IRA is like a trasditional 401(k). Contributions can be tax deductible, assuming you and your spouse aren’t also participating in an employer sponsored retirement plan. If so, the amount you can deduct will depend on your earnings. Either way, traditional IRA contributions grow on a tax-deferred basis. RMDs also apply.

Roth IRAs are funded with money you’ve already paid taxes on. That means you can withdraw your contributions any time you like — no taxes or penalties. Earnings are up for grabs too, as long as you’ve had the account for five years and are at least 59 ½. This doesn't necessarily fit the intentions of the plan, though. Doing so could deplete your retirement savings and prevent you from netting future investment returns. 

Contributions to a Roth IRA are not tax deductible. RMDs also won’t apply during your lifetime, but you’ll need to meet certain income requirements to contribute.

IRA withdrawals

• Traditional IRAs: You won’t be taxed until you withdraw your funds. Just know that if you do this before 59 ½, you’ll likely get hit with an additional 10% early withdrawal penalty.

• Roth IRAs: You can dip into your contributions at any time, penalty- and tax-free. You can also withdraw earnings if you’ve had the account for a minimum of five years and you’re 59 ½ or older.

Again, depleting your IRAs could leave you short of your retirement income goal. You could rob yourself of future potential returns as well so tread carefully. It underscores just how important it is to have an emergency fund.

Key differences between IRA and 401(k)

You can contribute much more to 401(k) plans

While both have contribution limits, you can contribute more to a 401(k) then an IRA.

401(k) plans are only available through an employer

If your employer doesn’t offer a retirement plan, you can open a traditional or Roth IRA through a broker or participating financial institution. But 401(k) plans must be employer-sponsored. Self-employed folks might look into a solo 401(k), SEP IRA or SIMPLE IRA.

IRAs generally offer more investment options

With a 401(k), investment options are chosen by the plan administrator. This can feel limiting to someone who wants to take a more active role in their investment portfolio. IRAs are usually more flexible, providing greater investment options. You can choose them yourself, or use a robo-advisor to select investments on your behalf based on factors like your age and risk tolerance.

Is a 401(k) an IRA?

The short answer is no. A 401(k) is an employer-sponsored retirement plan. An IRA is a retirement account you can open and manage on your own. When it comes to the IRA vs 401(k) debate, it’s important to understand that both types of accounts can help you build your nest egg and save for the future — and enjoy some tax advantages along the way. 

You can certainly have both if that suits you. The most important thing is choosing a long-term investment strategy that’s tailored to your risk appetite and financial goals. That’s where Acorns Later can come in handy. Answer a couple of simple questions and we’ll match you to an IRA plan that fits your situation.