IRA vs 401k Explained

Determining what investment account is right for you is essential to retirement planning. Here's a breakdown of IRA and 401k accounts so you can make the best choice for your future.

IRA accounts explained

IRA stands for individual retirement account. It's an investment account that allows you to save for retirement on a tax-deferred basis, meaning you don't pay taxes on contributions until you withdraw the money.

IRA accounts come in two main types: traditional IRA and Roth IRA. With a traditional IRA, you get an up-front tax deduction for your contributions. With a Roth IRA, you don't get an up-front tax deduction, but your withdrawals in retirement are tax-free.

Both account types have different eligibility requirements, contribution limits, and withdrawal rules. For example, your income must be below a certain threshold to contribute to a Roth IRA. And if you withdraw money from a traditional IRA before age 59 1/2, you'll have to pay taxes and a 10% early withdrawal penalty.

401k accounts explained

401ks are employer-sponsored retirement savings plans. They get their name from the IRS code section that governs them - 401k is shorthand for section 401(k) of the Internal Revenue Code.

401k accounts are one of the most popular retirement savings vehicles in the United States. They offer several advantages, including tax breaks, employer matching contributions, and a wide variety of investment options.

Employers often provide investment choices for their employees, including mutual funds, index funds, and company stock. Some 401k plans also offer Roth 401k options, which work like Roth IRAs.

Like IRA accounts, 401k accounts have rules about eligibility, contributions, and withdrawals. 

Defined benefit vs. defined contribution plans

Defined benefit plans, also known as pension plans, are another employer-sponsored retirement savings plan. With a defined benefit plan, your employer promises to pay you a certain amount in retirement based on your years of service and salary history.

Defined contribution plans, typically a 401k, are the most common type of employer-sponsored retirement savings plan. With a defined contribution plan, you and your employer contribute money to your account. The money in your account grows over time, and you can use it to pay for retirement expenses.

Employer contributions

401ks often have employer contributions. Employers will match a certain percentage of employee contributions up to a limit. For example, an employer might match 50% of employee contributions, up to 6% of their annual salary.

IRA accounts don't have employer contributions. You can only contribute to an IRA if you have earned income from a job or self-employment.

IRA contribution limits

IRA contribution limits change over time.  For 2022, the IRA contribution limit is $6,000. If you're 50 or older, you can contribute an additional $1,000, for a total of $7,000. This is referred to as a "catch-up contribution."

IRA contributions are also limited by income. Your income must be below a certain threshold to contribute to a traditional IRA. For example, in 2022, the contribution limit for someone who is single and covered by a workplace retirement plan is $6,000 if their modified adjusted gross income (MAGI) is below $68,000. If you don't have a workplace retirement plan, you can deduct the full amount of your traditional IRA contribution.

Roth IRA contributions also have income limitations. Your income must be below a certain threshold to contribute to a Roth IRA. For example, in 2022, the Roth IRA contribution limit for someone who is single and covered by a workplace retirement plan is $6,000 if their modified adjusted gross income (MAGI) is below $129,000. Contributions begin phasing out over the income threshold and are not allowed if your MAGI exceeds $144,000.

401k contribution limits

401ks have significantly higher contribution limits than IRAs.  For 2022, the 401k contribution limit is $20,500. If you're 50 or older, you can contribute an additional $6,500, for a total of $27,000. This is referred to as a "catch-up contribution."

Contributions to traditional 401k accounts are deductible and grow tax-deferred until withdrawal. With a Roth 401k, contributions are made with after-tax dollars, but withdrawals in retirement are tax-free.

The 401k contribution limit is much higher than the IRA contribution limit.

401k and IRA withdrawal rules

IRA and 401k withdrawal rules are different. With an IRA, you can begin withdrawing at age 59 1/2 without paying taxes or penalties. With a 401k, you may be able to start taking withdrawals at age 55 if you leave your job. You'll pay taxes and a 10% early withdrawal penalty if you don't meet these criteria.

IRA and 401k accounts have different required minimum distributions (RMDs) rules. An RMD is the minimum amount of money you must withdraw from your retirement account each year. With an IRA, you must start taking RMDs at age 72. These rules are subject to change, and the IRS maintains a retirement plan and IRA required minimum distribution FAQ.

IRA vs. 401kComparison

Here's a quick breakdown of the similarities and differences between 401ks and IRAs.

• Both account types have traditional and Roth choices.
• 401ks have significantly higher contribution limits than IRAs.
• Employers may contribute to a 401k plan but not an IRA.
• IRAs tend to have significantly more investment options because they are self-directed and not subject to the employer's menu of investment choices.
• Both account types are subject to early withdrawal penalties, but 401ks have an earlier distribution option if you leave your job.