IRAs and 401(k)s are both retirement accounts that offer tax benefits. The main difference between them is that a 401(k) is an employer-sponsored plan, while IRA accounts are opened by an individual.
When considering a 401(k) vs IRA plans for retirement savings, you may not have to choose one over the other. You may be able to contribute to both at the same time.
An IRA offers a choice of more investment options. However, there are limits to the annual contribution, more so than with a 401(k).
What is a 401k?
A 401(K) is a retirement savings plan that is sponsored by your employer. The company will set up this plan for its employees to save for retirement.
Employer plans often provide a matching contribution. This is done to incentivize employees to save for their retirement.
The plans generally offer multiple, diversified investments that are usually chosen by your 401(k) sponsor. This plan sponsor could be your employer or another fiduciary chosen by the employer. Most 401(k) plans offer a lineup of various mutual funds.
| 401(k) | Overview |
|---|---|
| Set up by | Your employer |
| Maximum Contributions 2022 | $20,500 or $27,000 if you’re over 50 |
| Pros | • High annual contribution limit • Pre-tax or post-tax dollars • Potential tax break on current income taxes • Often provide set it and forget it options for bands off investors • No income limit |
| Cons | • No control over provided investment fund lineup • Limited options for investments • Retirement withdrawals are subject to income tax |
The plan offers a high annual contribution rate of up to $20,500 per year (2022). For savers over 50 years old, the IRS allows “catch-up” contributions for a total opportunity of up to $27,000 in retirement savings in 2022.
Catch-up contributions are an option to allow late starters to increase their savings before retirement.
The catch-up contribution of $6,500 extra allows people closer to retirement to boost their savings. Along with personal and employer contributions, there is a combined limit of $61,000 ($67,500 for those eligible to make catch-up contributions) for 2022.
Contributions to a 401(K) are often made with pre-taxed dollars. The main benefit of this is that the contributions are tax-deductible.
Therefore, contributions can potentially reduce your taxable income for the year by the amount contributed. This means you may have a lower tax bill and will have the opportunity to earn compound investment returns on pre-tax dollars.
Contribution details can be found here.
The 401(k)-penalty free withdrawal age is 59.5 years. This is generally the earliest age one may begin taking withdrawals without penalty. Once you start withdrawing your funds, these withdrawals are subject to income tax.
Two options to access funds earlier (which some 401(k)plans allow) are to apply for a loan against your 401(k) or make a hardship withdrawal.
Unfortunately, the loan will be paid back over time with after-tax dollars. A hardship withdrawal will count as taxable income AND will be subjected to a 10% early withdrawal penalty.
Besides 401(k) accounts, there are multiple options for individuals to save for retirement. These retirement accounts include traditional IRAs, Roth IRAs, SEP, and SIMPLE IRAs.
Here is a breakdown of the differences between them.
Traditional IRAs and Roth IRAs
Almost every financial services provider offers IRAs. Some examples of IRA providers include the following:
1. Banks
2. Credit Unions
3. Investment Companies
4. Mutual Funds Companies
5. Online Brokers
Saving for retirement can seem overwhelming but starting early and knowing how much you need to save will have you headed in the right direction.
What is an IRA?
A traditional IRA is an account set up by an individual through a financial services provider to save for retirement.
For most taxpayers, funds deposited are tax-deductible. The IRS does set income limits for deductions and they can be found here.
For most taxpayers, funds deposited are tax-deductible. The IRS does set income limits for deductions and they can be found here.
The contribution maximum for a traditional IRA is much less than a 401(k). Like a 401(k), taxes on the account earnings are not due until withdrawals are taken.
| Traditional IRA | Overview |
|---|---|
| Set up by | You – through a financial services provider |
| Maximum Contributions 2022 | $6,000 or $7,000 if you’re over 50 |
| Pros | • Large number of investments • Pre-taxed dollars saved • Potential tax break on current income taxes |
| Cons | • Contribution limit is low • Retirement withdrawals are subject to income tax • Potentially higher administration costs • Withdrawals earlier than 59.5 years of age may be subject to a 10% penalty |
For 2022, annual contribution limits are $6,000, or for people over 50 years old $7,000.
Traditional IRAs are self-directed investmnet accounts that allow you to have a wide range of investment options.
Depending on the financial services provider you choose to open an IRA with, you can invest in stocks, bonds, mutual funds, cryptocurrency, real estate, or even peer-to-peer lending.
Like your 401(k), you can begin withdrawals at 59.5 years old, which is when you will start paying income tax on the funds withdrawn.
Withdrawals prior to age 59.5 years old may be subject to a 10% early withdrawal penalty as well as income tax.
The maximum age that you can push off withdrawals from your traditional IRA is 72 years old and is known as an RMD.
Do you know your net worth prior to retirement? Find out more here.
Traditional IRAs are generally opened by investors with the concept that you do not pay tax on the funds now, this will allow you to potentially pay less on your current income taxes and enjoy tax-deferred growth.
When withdrawals do occur, you may be in a lower tax bracket because you are retired. This would hopefully allow you to pay much less tax on the money than if you had paid it while working.
What Is a Roth IRA?
The main difference between a traditional IRA and Roth IRA is when your account gets taxed. Traditional IRA account contributions are pre-tax dollars whereas Roth IRA contributions are after-tax dollars.
Income tax is paid now and the earnings in the account will grow tax-free over time. If withdrawals occur after age 59.5 and you satisfy the requirements, there will be no taxes due.
| Roth IRA | Overview |
|---|---|
| Set up by | You – through a financial services provider |
| Maximum Contributions 2022 | $6,000 or $7,000 if you’re over 50 |
| Pros | • Large number of investment options • Retirement withdrawals tax free • Withdrawals can be done penalty-free at any time |
| Cons | • Contribution limit is low • No immediate tax break on income taxes • Potentially higher administration costs |
Roth IRA contributions are after-tax dollars. There is no immediate tax benefit to a Roth account. Because you have already paid tax on these dollars, all money inside the fund is not subject to tax. Not even the interest or earnings!
Your investment will grow tax-free. A Roth IRA is not subject to tax at retirement.
Contribution limits are the same as a traditional IRA at $6,000 annually or $7,000 for people over 50 years of age. It is possible to have a traditional IRA and a Roth IRA account at the same time.
💡 Note: It is important to note that those contribution limits are for combined IRA accounts.
SEP IRAs
A Simplified Employee Pension is formed by employers and those self-employed. Employers make tax-deductible contributions on behalf of their employees or themselves into a SEP IRA.
SEPs are similar to traditional IRAs. Since they are contributing untaxed dollars, employees can earn a tax break by lowering their annual taxable income by the contribution amount.
| SEP IRA | Overview |
|---|---|
| Set up by | Your employer or yourself if you are self-employed |
| Maximum Contributions 2022 | You can contribute up to 25% of your income up to the value of $61,000 |
| Pros | • High annual contribution limit • Can combine with a traditional IRA or Roth IRA • Contributions are tax-deductible • Potential tax break on current income taxes |
| Cons | • Retirement withdrawals are subject to income tax • Employers are required to contribute proportionally • Withdrawals earlier than 59.5 years of age may be subject to a 10% penalty |
The most significant advantage of having a SEP IRA account is that it has a much higher annual contribution limit than traditional IRAs.
Contributions can be up to 25% of the employee’s compensation for the year or the maximum amount of $61,000 for 2022.
SEP IRAs are beneficial for those that are self-employed or those employers that want to make a matching contribution to their employee’s retirement accounts.
SEPs are treated like traditional IRAs by offering the same investment options and tax benefits.
It is beneficial for employers to contribute because they receive a tax deduction. Businesses also do not have to commit to an annual contribution and can adjust their amounts annually.
SIMPLE IRAs
A SIMPLE IRA plan (Savings Incentive Match Plan for Employees) is suited to small employers of less than 100 employees that are not currently sponsoring a retirement plan such as a 401(k).
| SIMPLE IRA | Overview |
|---|---|
| Set up by | Your employer |
| Maximum Contributions 2022 | $13,500 or $16,500 if you’re over 50 |
| Pros | • Large number of investment options • Eligibility requirements are low • Plan option for employers that cannot offer a 401(k) • Less paperwork and admin burden for employers |
| Cons | • Employer contributions are mandatory • No Roth option • Withdrawals earlier than 59.5 years of age are subject to a 25% penalty • Employers may not provide another retirement plan |
SIMPLE IRAs are designed for employers that want to contribute to their employee’s individual retirement plan.
Employers can make up to 3% matching retirement account contributions or offer an across the board 2% (the 2% doesn’t require employee contributions) account contribution for all employees.
Annual SIMPLE IRA contributions cap out at $14,000 annually as of 2022.
Catch-up contributions for over 50-year-old retirement savers can add an additional $3,000.
The SIMPLE IRA is beneficial to employers as there is very little extra paperwork involved in setting up and managing their accounts.
The account is opened through a financial services provider that manages most of the administration and documentation.
Unlike a SEP IRA, with a SIMPLE IRA, the employer must contribute to the accounts every year. The employer may change between the 3% matching contributions to the 2% across-the-board contributions if they follow IRS rules.
To participate in your employers, SIMPLE IRA plan employees must have earned more than $5,000 in any two previous calendar years and are expected to earn a minimum of $5,000 in the year that they take part in the plan.
Employers can also choose to exclude participant employees if they receive alternative compensation through unions.
Traditional IRA vs 401k
If your employer offers a 401(k) with matching contributions, take advantage and enroll! This is as close to free money as you can get.
If your employer’s 401(K) doesn’t offer great investment options, then only put what you need to in to get the full benefit of any employer match contributions and put the rest of your savings into an IRA.
If your employer only offers a SEP IRA or SIMPLE IRA, and you still have the financial capacity to open a traditional IRA do that as well.
Saving for retirement as early as possible will fundamentally change your future. Opening an IRA and contributing money through your employer 401(k) or SEP IRA account annually will really add up over time.
Your savings combined with employer contributions will slowly grow, and over time you may have a sizable nest egg for your future.
Roth IRA vs 401k
Both a Roth IRA and a 401(k) plan allow you to grow your savings for retirements.
While there are no tax deductions for Roth IRA contributions, the funds can be withdrawn tax-free in retirement.
Roth IRA contributions are limited to $6,000 if you are under the age of 50 years, or $7,000 if you are older than 50 years.
The contributions for 401(k) plans in 2022 are limited to $20,500 per year for employees under 50 years, and $27,000 per year for those older than 50 years.
Sources
- IRAaccessed on July 14, 2022
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