If you're choosing a retirement savings vehicle, you may be wondering if it matters where you save your money. Individual retirement accounts (IRAs) and 401(k)s are among the most popular ways to save for retirement, but these two savings account types have distinct features, and understanding the key differences between them can help you decide whether to leverage one or the other — or both.
IRA vs. 401(k): What Are the Pros and Cons of Each?
Here we will compare and contrast the most important aspects of IRAs and 401(k)s so you can determine which account type makes the most sense for your retirement planning.
If you have earned income, you're likely eligible to contribute to an IRA. 401(k) plans, on the other hand, are workplace retirement plans, so you can only contribute if your employer offers this type of retirement plan. You may be able to contribute to both types of accounts, but be sure to discuss the tax rules with a financial advisor or CPA to avoid any problems.
It's ideal to have a 401(k) if you want to save a substantial amount for retirement. IRAs allow you to contribute up to $6,000 per year, and if you're age 50 or older, you can contribute an additional $1,000 as a catch-up contribution.
The maximum contribution for a 401(k) plan is significantly higher, allowing you to defer up to $19,500 of your pay into your plan. When you're over age 50, you can increase that by another $6,500 as well. Plus, your employer can match your contribution or provide additional funds, such as profit-sharing dollars.
Both 401(k) plans and IRAs may allow for pretax and after-tax contributions. However, your ability to use those options depends on several factors, so it's critical that you discuss the pros and cons of an IRA vs. 401(k) with your tax professional before you make a decision. Be sure to consider the following differences with respect to taxation in particular.
- IRAs: Anybody with earned income can make non-deductible contributions to an IRA. However, to contribute to a Roth IRA, your income must be below a specific level. In terms of pretax contributions, your workplace retirement plan and your income can affect whether or not you qualify for a deductible contribution.
- 401(k)s: Your employer decides what types of contributions are allowed with a 401(k). As long as you're eligible to participate, you can typically choose how to allocate your contributions. For example, you could opt for pretax, Roth or a little bit of both.
With an IRA, you typically have a broad range of investment options. Depending on where you open an account, you can invest in mutual funds, ETFs, individual stocks, cash, CDs, annuities or other vehicles. IRAs offer more flexibility than most 401(k) plans.
A 401(k) plan often has a menu of investments that your employer chooses. In many cases, you can invest in mutual funds, ETFs or similar instruments that focus on diversifying into numerous investments.
An IRA is an account you control, so you can generally withdraw funds whenever you need. It may take several business days for funds to become available, and some investment providers set restrictions on withdrawals, but IRAs can provide easy access to your funds.
401(k) plans have rules that limit withdrawals. For example, you might need to stop working at your job, reach a certain age or satisfy some other condition to access your money. Unlike IRAs, 401(k) plans can offer loans, though that's an optional feature your employer must enable.
The Bottom Line
Both IRAs and 401(k) plans can help you save for retirement, manage taxes and invest your money. 401(k) plans can allow you to maximize your savings, but IRAs offer the most flexibility in terms of investment options and withdrawals. Fortunately, you don't need to choose between the two, as you may be able to contribute to both types of accounts. By doing so, you can design a customized strategy that leverages the features that matter most to your retirement goals.