Understanding the Differences Between 401(k) and IRA: A Comprehensive Guide
When it comes to saving for retirement, two of the most popular options are individual retirement accounts (IRAs) and 401(k) plans. Both of these retirement tools offer significant tax advantages and are relatively easy to set up. However, there are key differences between the two that can impact your decision on which one to choose. In this blog, we will explore the ins and outs of IRAs and 401(k)s, their benefits, and how to decide which one is right for you.
What Is a 401(k)?
A 401(k) is a tax-advantaged retirement savings plan offered by many employers. Under a traditional 401(k) plan, you can have a portion of your paycheck automatically directed to your retirement savings. These contributions are excluded from your gross pay, reducing your taxable income. While your money grows in the account, you won’t pay income taxes on the earnings. However, you will pay taxes on the money you withdraw during retirement.
Employer Matching
One of the significant benefits of a 401(k) plan is employer matching. Some employers match your contributions up to a certain percentage of your salary. For example, if your employer matches 100% of your contributions up to 3% of your salary, and you earn $60,000 a year, you can contribute $1,800, and your employer will match it with an additional $1,800. This effectively doubles your contribution.
Vesting
Vesting refers to the ownership of the employer’s contributions to your 401(k) plan. Depending on your employer’s policy, you may lose a portion of your contributions or employer matching funds if you leave your job before you’re fully vested. Vesting rules vary: some plans vest an employee immediately, some do so gradually, and others vest fully after several years.
Contribution Limits
For the 2023 tax year, you can contribute up to $22,500 to a 401(k) plan. If you’re age 50 or older, you can contribute an additional $7,500, making the total contribution limit $30,000. These limits do not include employer matching dollars. Your total contributions, including employer matching, can’t exceed 100% of your compensation or $66,000 for 2023.
Early Withdrawals
You can begin withdrawing money from your 401(k) plan starting at age 59½. If your plan allows early withdrawals, the IRS assesses a 10% early withdrawal penalty in addition to regular income taxes on the distribution amount. Exceptions to the 10% penalty may apply in cases of financial hardship.
What Is an IRA?
IRAs are not linked to your employment and are available to anyone with taxable compensation. You can open and fund an IRA independently through banks, credit unions, brokerages, and mutual fund companies.
Types of IRAs
There are several types of IRAs, each with its own set of rules and benefits:
- Traditional IRAs: Contributions are tax-deductible, and you won’t pay taxes on your money as it grows. However, you will pay taxes on withdrawals during retirement.
- Roth IRAs: Funded with after-tax dollars, meaning no tax deduction. Money grows tax-free, and withdrawals during retirement are not taxed.
- Spousal IRAs: Allow non-working spouses to contribute to their retirement even if they don’t have qualifying taxable income.
- Rollover IRAs: For funds rolled over from past 401(k)s and IRAs.
- SEP IRAs: Simplified Employee Pension IRAs allow business owners to contribute to both their employees’ and their own retirement savings. Only employers may contribute.
- SIMPLE IRAs: Savings Incentive Match Plan for Employees IRAs allow elective contributions from employees, similar to a 401(k).
Contribution Limits
The IRS limits the amount of money you can put into an IRA each year. For 2023, the IRA contribution limit is $6,500, with an additional $1,000 catch-up contribution for people age 50 or older. Your IRA contribution can’t be greater than your income.
Early Withdrawals
A 10% early withdrawal penalty and regular income taxes apply if you withdraw funds from a traditional IRA before you reach age 59½, unless you meet an exception. You can withdraw the contributions you’ve made to a Roth IRA at any time without penalty, but you’ll pay a 10% penalty and income taxes on any earnings you withdraw early.
Key Differences Between IRAs and 401(k)s
Sorting out the differences between IRAs and 401(k)s can seem complicated. Here are some key differences:
| Feature | 401(k) | IRA |
|---|---|---|
| Eligibility | Must be eligible according to your employer’s plan policies | Available to anyone with taxable compensation |
| Contribution Limits | $22,500 ($30,000 if age 50 or older) | $6,500 ($7,500 if age 50 or older) |
| Employer Matching | May match (or partially match) your contributions | Matching doesn’t apply |
| Portability | Roll funds over into a new employer’s 401(k) or a rollover IRA | Funds stay in your account until you withdraw them or move accounts |
| Vesting | May require a vesting period before funds are fully yours | Funds are not subject to vesting |
| Early Withdrawal Rules | 10% penalty on withdrawals made before age 59½ (unless an exception applies) | 10% penalty on withdrawals made before age 59½ (unless an exception applies) |
| Loans | Plan may allow you to borrow up to 50% of your account’s value, or a maximum of $50,000 | Loans against IRAs are not allowed |
| Required Minimum Distributions | Must be taken starting at around age 73 | Must be taken from a traditional IRA starting around age 73; no required minimum distributions for Roth IRAs |
| Roth Option | Some employers offer Roth 401(k)s | Roth IRAs are a ready alternative to traditional IRAs |
How to Choose Between an IRA and a 401(k)
Both 401(k) plans and IRAs are essential tools for saving for retirement. Here are some perspectives to consider when deciding between the two:
When to Choose a 401(k)
If your employer offers a 401(k) plan, it’s worth considering. Elective deferrals taken out of your paycheck make it easy to invest regularly. Matching funds provide an immediate return on your investment, though you may have to wait to become fully vested before all of your funds are yours. Higher contribution limits mean it’s possible to save more money quickly.
When to Choose an IRA
An IRA is a great alternative when a 401(k) plan isn’t available to you, such as if you’re self-employed or a non-working spouse. IRAs are easy to open and can be established at most banks, credit unions, mutual fund companies, or investment brokerages. An IRA is also a simple option if you have a lump sum to contribute.
Why Not Choose Both?
If you have enough money to invest, you may want to contribute to both a 401(k) and an IRA. The IRS has income limits that may affect your ability to make a Roth IRA contribution or deduct a traditional IRA contribution when you or your spouse also contribute to a workplace retirement plan. But as long as you’re eligible, you might consider contributing to both types of accounts if you’ve maxed out your 401(k) contributions (or employer match), or if you’re interested in options that aren’t available through your employer’s 401(k)—for example, a Roth account.
Maintaining both a 401(k) and an IRA requires a bit more effort: You’ll have multiple accounts to track. But, if you have the funds, contributing to both a 401(k) and an IRA lets you maximize your tax-advantaged savings.
The Bottom Line
Saving for retirement is a marathon, not a sprint. Using tax-advantaged accounts like 401(k)s and IRAs can help you build your nest egg over time. Participating in your employer’s 401(k) plan can help you save consistently and take advantage of matching funds. Opening and funding a traditional or Roth IRA gives you an additional opportunity to save—and save money on taxes. Either type of account can help you meet your retirement goals. Over the long haul, if you’re serious about saving for retirement, you may want both.
At O1ne Mortgage, we understand the importance of planning for your future. If you have any questions or need assistance with your mortgage needs, don’t hesitate to call us at 213-732-3074. Our team of experts is here to help you every step of the way.
