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IRA vs 401(k)

Key Takeaways:

  • A 401(K) is a retirement savings plan that is sponsored by your employer.
  • The main benefit of a 401(k) is that the fund contribution is tax-deductible.
  • The 401(k) withdrawal age is 59.5 years old.

IRAs and 401(k)s are retirement accounts, and both offer tax benefits. The main difference between them is that a 401(k) is an employer-sponsored plan, while IRA accounts are opened personally.

When you compare a 401(k) vs IRA plans, you do not have to choose one or the other, you can contribute to both at the same time.

An IRA offers more investment options to choose from. 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, meaning they set it up and typically make contributions to it.

Employer plans often provide a matching contribution incentive where to a point, they will match your contributions.

The money is diversified into multiple investments that are usually chosen by your sponsor, such as mutual funds.

401(k)Overview
Set up byYour employer
Maximum Contributions 2021$19,500 or $26,000 if you’re over 50
Pros• High annual contribution limit
• Pre-taxed dollars saved
• Potential tax break on current income taxes
• No personal management required
• No income limit
Cons• No say investment fund control
• Limited options for investments
• Retirement withdrawals are subject to income tax

The plan offers a high annual contribution rate of up to $19,500 per year (2021). For contributors over 50 years old, the annual rate increased to $26,000, allowing late starters to increase their savings before retirement.

The catch-up contribution of $6,000 extra allows people close to retirement to boost their savings. Along with their personal contributions, an employer can match your contributions to a combined limit of $56,000 per year.

Contributions to a 401(K) are made with pre-taxed dollars. The main benefit of this is that the fund contribution is tax-deductible.

Therefore it can potentially reduce your income tax for the year by the amount contributed.

Another benefit of pre-tax contributions is that you are investing more money throughout your working life.

You will receive investment income that accrues and compounds on pre-tax dollars.

Contribution details can be found here.

The 401(k) withdrawal age is 59.5 years. That is the earliest age to begin taking withdrawals without penalty. Once you start withdrawing your funds are then subject to income tax.

If you withdraw earlier, you can apply for a loan against your 401(k) or make a hardship withdrawal. Still, you will be charged a 10% early withdrawal fee along with income tax.

These days there are multiple types of Individual retirement accounts known as IRAs, traditional, Roth, SEP, and SIMPLE IRAs.

Here is a breakdown of the differences between them.

Traditional IRAs and Roth IRAs

Almost every financial institute offers IRAs. You can choose from whoever you feel comfortable with.

1. Banks

2. Credit Unions

3. Investment Companies

4. Mutual Funds Companies

5. Online Brokers

Saving for your retirement can seem overwhelming but starting early and knowing how much you need to save will head you in the right direction.

What is an IRA?

A Traditional IRA is an account set up personally through a financial institute to save for retirement. All funds deposited are tax-deductible.

The contribution maximum for a traditional IRA is much less than a 401(k). They are generally tax-deductible earnings. You do not have to pay tax on the account until withdrawals in retirement.

Traditional IRAOverview
Set up byYou – through a financial institute
Maximum Contributions 2021$6,000 or $7,000 if you’re over 50
Pros• Large investment options
• Pre-taxed dollars saved
• Potential tax break on current income taxes
Cons• Contribution limit is low
• Retirement withdrawals are subject to income tax
• Potential higher administration costs
• Withdrawals earlier than 59.5 years of age are subject to a 10% penalty

Annual contribution limits are $6,000, or for people over 50 years old $7,000.

Traditional IRAs are self-directed investments that allow you to have much more flexibility in what you invest in.

Depending on what financial institute you open your IRA, you can invest in stocks, bonds, mutual funds, and even peer-to-peer lending.

Like your 401(k), you can begin withdrawals from 59.5 years old, which is when you will start paying income tax on the funds.

Prior withdraws are subject to a 10% early withdrawal penalty as well as income tax.

The maximum age that you can begin withdrawals from your traditional IRA is 70.5 years.

Do you know your net worth prior to retirement? Find out more here.

Traditional IRAs are set up 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.

When you do get taxed because you are retired, and chances are your income is lower when you do get taxed, you are going 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 account contributions are pre-tax dollars whereas Roth IRA contributions are after-tax dollars.

Income tax is paid in retirement once withdraws commence.

All contributions are tax-deductible and can reduce your annual taxable income, which will, in turn, reduce their end-of-the-year tax bill.

Roth IRAOverview
Set up byYou – through a financial institute
Maximum Contributions 2021$6,000 or $7,000 if you’re over 50
Pros• Large investment options
• Retirement withdrawals tax free
• No minimum age with withdrawals
Cons• Contribution limit is low
• No immediate tax break on income taxes
• Potential higher administration costs

With Roth IRAs’ 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!

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 $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 Employment Pension IRA is formed by employers and those self-employed. Employers make tax-deductible contributions on behalf of their employees or selves into a SEP IRA.

SEPs are similar to traditional IRAs. Because they are contributing untaxed dollars, employees can gain a tax break by lowering their annual taxable income by the contribution amount.

SEP IRAOverview
Set up byYour Employer or Yourself if you are self-employed
Maximum Contributions 2021You can contribute up to 25% of your income up to the value of $58,000
Pros• High annual contribution limit
• Can combine with a traditional IRA or Roth IRA free
• 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 are subject to a 10% penalty

The most significant advantage of having a SEP 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 $57,000 for 2021.

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 purposes.

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 change their amounts annually.

SIMPLE IRAs

A SIMPLE IRA plan (Savings Incentive Match Plan for Employees) is suited to small employers of less than 100 staff that are not currently sponsoring retirement plans such as a 401(k).

SIMPLE IRAOverview
Set up byYour employer
Maximum Contributions 2021$13,500 or $16,500 if you’re over 50
Pros• Large investment options
• Eligibility requirements are low
• A plan option for employers that cannot offer a 401(k)
• Low paperwork and admin time for employers
Cons• Employer contributions are mandatory
• No Roth options
• Withdrawals earlier than 59.5 years of age are subject to a 25% penalty
• Employers cannot have another retirement plan

SIMPLE IRAs are designed for employers that want to make a contribution to their employee’s individual retirement plan.

Employers can make up to 3% matching retirement account contribution 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 $13,500 annually as of 2021.

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 up through a financial institute that takes care of the majority of the documentation.

Unlike a SEP IRA with a SIMPLE IRA employer must contribute to it every year. They can 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 this year.

Employers can also choose to exclude participant employees if they receive alternative compensation through unions.

IRA vs 401k

If your employer offers a 401(k) with matching contributions, definitely set that up.

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 your employer contributions and put the rest of your savings into an IRA.

If your employer only offers SEPs or SIMPLES 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 putting money through your employer into your 401(k) or SEP IRA annually will add up over time.

Your savings combined with employer contributions will slowly grow, and over time you will 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 tax-free.

However, there are no tax deductions for Roth IRA contributions, and contributions 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 2021 are limited to $19,500 per year for employees under 50 years, and $26,000 per year for those older than 50 years.

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    AuthorKimberley Smyth

    Kimberley is the US Country Manager for Financer.com. She has gained years of experience in small business management and has two successful start-ups under her belt. She now focuses her energy on helping others achieve financial freedom through smart money management and investment opportunities.

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    Last Updated: October 25, 2021

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