IRA vs 401k: Which Retirement Account Should You Choose?

Last Updated on February 1, 2022 by pf team

Most people choose an IRA vs 401k to grow their investment savings and — depending on the type of plan — either defer taxes until retirement age or enjoy tax-free qualified withdrawals.

Saving for retirement can seem overwhelming but you have some great tools available to help you reach your goals in a tax advantaged way.

IRA vs 401k
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IRA vs 401k

While both an IRA and 401k (or equivalent) can help you to reach your retirement goals, each has distinct advantages and choosing the right investment account type often depends on your unique situation.

It’s important to weigh the pros and cons of each. In some cases, when choosing between an IRA and 401k the right answer might be both.

What is an IRA plan?

An IRA is an Individual Retirement Account and can take the form of an investment account or savings account, or can even hold real estate and other types of assets.

There are actually 7 types of IRAs but 2 types of IRAs are the most commonly used: Traditional IRA and Roth IRA.

Each has unique advantages and, in some cases, it might make sense to use both as part of your retirement savings strategy.

IRAs are a popular choice either to complement an existing retirement plan, like a 401k, or as a separate option when a 401k isn’t available, such as in the case of self-employment or when working for an employer that doesn’t offer a 401k.

Traditional IRAs and Roth IRAs are easy to access because they are available through major brokers and even through banks or credit unions.

Brokerage IRAs provide more investment options, including stocks, mutual funds, and ETFs, and are a better fit for most people — particularly younger savers.

Bank or credit union IRAs are often limited to CD accounts, which focus more on safety than on growth and which provide a lower average rate of return over time when compared to common investment options, like mutual funds or ETFs.

To examine how an IRA works, we can look at the two most common types of IRAs: Traditional IRAs and Roth IRAs.

A traditional IRA is a closer comparison to a 401k in regard to how the tax benefits of the account help your balance to grow over time.

Traditional IRA (pre-tax contributions)

In a traditional IRA, you can contribute to your account up to a maximum annual limit and the contributions you make to your account are tax-deferred.

Any growth in your account is also tax deferred. At withdrawal age, which is currently age 59 ½, you would pay taxes on the amount you withdraw each year as regular income according to your tax bracket at that time.

Here’s a simplified example:

Age 30 IRA contribution: $ 5,000

Balance at age 60: $87,000

In this case, you didn’t have to pay taxes on the $5,000 initial investment at the time you contributed to your account.

Assuming a 10% annual average return, which is close to the historical average annual rate of return for the S&P 500, your $5,000 investment can grow to nearly $90,000 over the course of 30 years.

None of this growth is taxed along the way. Any dividends you earn are also tax deferred.

No taxes are due until you withdraw money from your IRA, which allows your balance to grow without any tax headwinds.

When compared to a taxable individual investment account, the difference in account performance over time can be significant because with a taxable account, you would pay taxes on the initial $5,000, as well as on any dividends from your investment — and on any gains if you sell a position that has increased in value.

Of note, if you or your spouse have a 401k plan, you may not be able to deduct all of your IRA contributions, which can negate one primary advantage of a traditional IRA.

Roth IRA (post-tax contributions)

Named after Senator William Roth, the Roth IRA was introduced in 1997 and offers an attractive option to a traditional IRA.

With a Roth IRA, you don’t get the initial tax advantage found in a traditional IRA. The $5,000 from the earlier example is taxed.

However, the growth in the account is tax-free at retirement age. If you’re in the 22% tax bracket, the $5,000 of income you plan to invest may be reduced to $3,900 after taxes.

Here’s a simplified example:

Age 30 IRA contribution: $ 3,900

Balance at age 60: $68,000

Because your initial $5,000 is subject to income tax with a Roth IRA, you have less to invest and the long term value of the account is lower, assuming a 10% average annual return.

However, every cent of the balance is yours tax-free when you withdraw at retirement, which makes a Roth IRA an attractive option.

While a Roth IRA can help grow retirement savings, traditional IRAs are still more common and compare more closely with a traditional 401k.

Additionally, high income earners and those with certain tax filing statuses may be ineligible to contribute to a Roth IRA.

Pros of traditional IRAsCons of traditional IRAs
● You control your investment choices● Lower contribution limits
● Contributions may be tax-deductible● Penalties for early withdrawals
● Gains are tax-deferred● Restrictions on borrowing against your balance
● Accessible to most investors● Required withdrawals at retirement age

Pros of traditional IRAs:

  • You control your investment choices: You’ll find more investment options are available through most IRAs than through most 401k plans.
  • Contributions may be tax-deductible: A traditional IRA allows account contributions to be deducted at tax time. However, there may be some income-based limitations and contributions to a 401k account may reduce the amount you can deduct for IRA contributions if you or your spouse has a 401k.
  • Gains are tax-deferred: Capital gains and dividends in your account are not taxed while the funds remain in your IRA account. When funds are withdrawn, expect to pay taxes as regular income based on your tax rate at the time of withdrawal.
  • Accessible to most investors: Whereas, in most cases, access to a 401k is determined by your employer, an IRA is an individual investment account, allowing you to save for your future even if your employer doesn’t offer a retirement plan.

Cons of traditional IRAs:

  • Lower contribution limits: IRA contribution limits are notably lower than those for 401k plans. For 2019, the maximum contribution limit for a traditional IRA plan is $6,000. Retirement savers over age 50 can contribute an additional $1,000 each year. By comparison, the contribution limit to a 401k or equivalent plan is currently $19,000.
  • Penalties for early withdrawals: Both a traditional IRA and a 401k are subject to early withdrawal penalties if you withdraw before age 59 ½. Roth IRAs differ in this regard, because you can take out your contributions at any time — but gains are subject to early withdrawal penalties.
  • Restrictions on borrowing against your balance: Strictly speaking, IRAs do not provide loan provisions. Money withdrawn from an IRA and not replaced or rolled into another IRA within 60 days is considered a withdrawal, making it taxable and possibly subject to penalties.
  • Required withdrawals at retirement age: RMDs refer to Required Minimum Withdrawals for IRA accounts. At age 70 ½, the IRS rules for IRA accounts instruct that a certain amount must be withdrawn each year. Roth IRAs are not subject to required withdrawals based on age.

What is a 401k plan?

A 401k plan is a workplace-based retirement savings plan with a similar tax-benefit structure to a traditional IRA — but with some key differences.

There are also several types of plans that are functionally equivalent to a 401k with the primary difference being who sponsors the plan.

For example, 403b plans, 457 plans, and Thrift Savings Plans, all have a similar structure to a 401k but may be sponsored by a non-profit employer or a government employer rather than a private employer.

With a 401k, you can make tax-deferred contributions, much like with a traditional IRA, but annual contribution limits are higher.

Currently, the maximum individual contribution limit is $19,000 annually. Rules can vary for high income earners.

Much like with a traditional IRA, your 401k balance can grow tax-free until withdrawal.

Withdrawal rules are similar as well, with 401k funds eligible to be withdrawn at age 59 ½ without an early withdrawal penalty.

At age 70 ½, you must begin withdrawing funds in accordance with IRS rules.

Withdrawals are taxed as regular income at your tax rate at the time of withdrawal.

Employer matching contributions

One of the biggest distinctions with a 401k is that IRS rules allow for employer-matching funds. What this means is that you can contribute to your 401k and your employer can contribute as well.

Employer contributions use various structures based on the amount you contribute and do not affect your contribution limit.

However, a new (higher) contribution limit for employee plus employee applies, currently the lesser of $56,000 or 100% of your annual salary.

The most common employer matching structure is 50% of your contribution — but with a cap at 6% of your salary.

A simpler way to think of this is that your employer matches up to 3% of your salary.

The actual employer match amount depends on your contribution amount, however.

Because the employer match is essentially free money that isn’t taxed until withdrawal, it’s best to contribute enough to your 401k to earn the maximum employer match.

Employer-match contributions can be subject to a vesting schedule, which means some of the money may not be yours if you leave the company before you are fully vested.

Immediate vesting is fairly common, but about half of employers that offer a 401k use a vesting schedule that can span 5 or 6 years based on your employment anniversary.

To revisit the simplified example from earlier, a 401k investment might look like this:

Your contribution at age 30: $5,000

Employer contribution: $2,250 (based on a $75,000 annual salary)

Total contribution: $7,250

Balance at age 60: $125,500 (based on 10% average annual growth)

In this example, the employer match was capped at 3% of salary, a common structure.

However, even when capped, the $2,250 employer match portion of the 401k contribution grows to over $39,000 over 30 years.

A 401k can provide measurable advantages if your employer provides matching contributions.

The higher contribution limit also allows you to put more money to work if you can afford to contribute higher amounts.

A 401k may not always be the ideal investment choice, however, largely because investment options within 401k’s themselves are often limited.

Pros of 401k plansCons of 401k plans
● Generous contribution limits● Limited investment choices
● Tax-deductible contributions● Not always available
● Taxes on gains deferred until withdrawal● Employer waiting period
● Loans and other emergency-based withdrawals permitted● Can affect tax-deductible IRA contributions
● Employer matching contributions● High fees

Pros of 401k plans

  • Generous contribution limits: With a $19,000 annual limit for individual contribution, a 401k lets you put more money to work. Plan participants age 50 and up can contribute an additional $6,000 per year.
  • Tax-deductible contributions: Contributions to your 401k are tax deductible, which allows you to invest more.
  • Taxes on gains deferred until withdrawal: Similar to a traditional IRA, taxes on gains and dividends are deferred until withdrawal.
  • Loans and other emergency-based withdrawals permitted: Unlike an IRA, a 401k allows loans up to $50,000 — or 50% of your balance, whichever amount is higher. Not all plans offer a loan provision and loans must be repaid via payroll deductions, which eliminates the possibility of borrowing from old 401k plans from a previous employer.
  • Employer matching contributions: Matching employer contributions are like free money — on which you don't pay taxes until withdrawal. In the interim, employer matching funds can grow to several times their original value given enough time.

Cons of 401k plans

  • Limited investment choices: Many 401k plans offer a limited selection of mutual funds from which to choose. Often, direct investments in individual stocks or ETFs aren’t a possibility.
  • Not always available: Media source might lead you to believe that most people have a 401k. Many employers don’t offer a retirement plan at all and even among those who do, many employers don’t offer an employer match program. One or more of the 7 types of IRAs can be a solution if a 401k or an equivalent isn’t available.
  • Employer waiting period: In addition to vesting schedules for employer contributions that apply to as many as half of all 401k plans, many plans impose a waiting period of 6 months to a year before employees are eligible to participate in the plan. The bottom-line result can be tens of thousands of dollars in lost investment gains over time.
  • Can affect tax-deductible IRA contributions: Participation in a 401k can affect your ability to deduct your IRA contributions in some cases. You can still contribute up to the annual IRA contribution limit, but you may lose a valuable tax benefit.
  • High fees: It isn’t uncommon to pay higher management fees for investment funds offered through 401k plans. Plan participants don’t have the same freedom to choose lower cost funds or ETFs commonly found with IRAs.

Who is eligible to participate in an IRA or a 401k?

For IRAs, the major qualification for participation is earned income, which refers to money paid for work or money earned in a business.

Dividend income, interest, and capital gains income don’t qualify. Even minors can contribute to an IRA if they have qualifying earned income.

After age 70 ½, you cannot open a traditional IRA or make contributions but you can still roll over another IRA or other qualified retirement account if needed.

With an IRA, the bigger question is often whether you can deduct the amount you contribute to your account.

This is largely driven by whether you or your spouse participate in a 401k plan and then follows a phase-out schedule based on income, which can reduce the amount you can deduct in some cases.

401k participation rules can vary, but the IRS does provide some guiding rules. Employees age 21 and over must be allowed to participate, assuming the employee also has at least one year of service.

However, employers have the latitude to reduce waiting periods and many companies allow participation after a 6-month waiting period.

Excluding workers younger than 21 isn’t uncommon because of the higher employee turnover often found with workers under this age.

A 401k cannot exclude a worker that is older than a specified age, however, which makes a 401k more inclusive than a traditional IRA which excludes new contributions once you reach age 70 ½.

Contribution limits for IRA vs 401k plans

Expect the IRA and 401k contribution limits to be revised every year or two as they were between 2018 and 2019. Both types of plans also offer a catch-up contribution based on age, allowing people nearing retirement to save at an accelerated rate.

Traditional IRA contribution limits:

For 2019, you can contribute up to $6,000, which is usually tax-deductible — but not always.

If you’re age 50 or older, you can contribute up to an additional $1,000 per year. At age 70 ½, you are no longer eligible to contribute and instead must begin taking your Required Minimum Distribution (RMD).

Roth IRA contribution limits:

Roth IRA accounts are subject to the same contribution limits as a traditional IRA: $6,000 under age 50 and $7,000 if 50 or older.

Unlike a traditional IRA, you can continue to make contributions to a Roth IRA at any age — if you have earned income — but you can’t contribute more than the annual limit or more than your earned income if your earned income is less than the limit.

It’s important to note that IRA contribution limits apply as a combined total for all your IRA accounts.

401k contribution limits:

A 401k has a most generous contribution limit. For 2019, the individual annual 401k contribution limit was raised to $19,000.

A separate contribution limit of $56,000 applies to combined employee and employer-match contributions.

An employer can contribute up to $37,000 without affecting your ability to maximize your individual contribution.

Investments options IRA vs 401k

Your investment options for a 401k and an IRA can vary but you’ll have more options when investing in an IRA. 401k plans usually focus on mutual funds and often only offer a handful of options.

Commonly, you’ll find a large-cap fund, a bond fund, an international or emerging growth fund, an index fund, and perhaps a few other options or even funds that hold both stocks and bonds.

Target date funds are also common. These funds allocate your investments automatically with your retirement year as the target date and begin to shift gradually to bonds as your retirement year approaches.

With an IRA, you have more options, including low-cost ETFs and direct investments in individual stocks.

IRAs can also hold mutual funds, US treasuries and bonds, annuities, CDs, or even investment real estate.

However, the rules on the latter are complex. Most retirement savers choose more common investments, like stocks, mutual funds, or ETFs.

What you’ll find is that you’ll have a much wider choice of investments with an IRA than with a 401k and you’ll have the freedom to change your asset allocation as you choose.

IRA vs 401k withdrawal rules

Both a traditional IRA and a 401k require withdrawals beginning at age 70 ½. The IRS provides guidance on required minimum distribution amounts.

There’s an exception for a 401k if you’re still working for the company that sponsors your 401k.

At the time of withdrawal you’ll pay income taxes on the amounts you withdraw, while the balance remains tax-deferred.At age 59 ½ you’re eligible to withdraw from either a 401k or an IRA without paying a penalty.

Withdrawals before age 59 ½ may be subject to a 10% penalty. For example, if you withdraw $10,000 early, expect to pay $1,000 to the IRS as a penalty.

The early withdrawal is also treated as income, which means you’ll pay taxes on it and, in some cases, may even be in higher tax bracket for that year as a result.

Costs for IRA vs 401k retirement plans

The cost structure for an IRA can vary considerably from a 401k. With a bit of shopping, you can find a no-cost IRA and may even be able to buy commission-free ETFs or no-load mutual funds.

More active traders or those investing IRA funds in stocks can expect higher trading costs for IRA investments. A 401k plan can have multiple fees — and while not hidden, they may not always be obvious.

401k fees include administrative or participation fees and investment fees.

401k fees are calculated as a percentage of your 401k balance, with larger plans typically having lower fees than plans offered through smaller employers.

Combined fees of over 2% of assets aren’t uncommon, making a 401k plan, on average, a more expensive choice than many IRA options.

What are the income tax implications?

Unless you choose a Roth IRA (or Roth 401k, if available), you won’t find many differences between the tax treatment for an IRA compared to a 401k.

Both plans provide the opportunity to invest with tax-deferred earnings and both plans have the same penalties for early withdrawals.

Both plans allow much faster growth when compared to a taxable investment account.

Taxes for both account types apply at the time of withdrawal and all distributions are treated as regular income for tax purposes, as opposed to capital gains or dividend income — which is how taxes would be applied in a taxable investment account.

However, contributions to a traditional IRA may not always be deductible. If you or your spouse has a retirement plan through an employer, you may be subject to an income-based phase-out that can reduce or eliminate IRA contribution deductions.

The biggest impact is for married tax filers filing jointly with a modified adjusted gross income of over $123,000, in which case there is no deduction.

Which is better IRA vs 401k

Both an IRA and a 401k bring unique advantages. A 401k has higher contribution limits, which makes it an attractive option.

The addition of matching contributions from an employer make a 401k even more appealing.

Effectively, employer matching contributions are free money — money that can grow for decades. If your employer offers a 401k and offers matching contributions, it’s wise to participate and to contribute enough to reach the maximum employer match.

However, be aware that participating in a 401k can affect your ability to deduct IRA contributions.

Many people have both an IRA and a 401k but for those without access to a 401k or a similar plan, an IRA is the logical choice for retirement planning.

Even with its lower contribution limits, a well-managed IRA can help fund your retirement if you make consistent contributions over time.

Maxing out the current annual contribution limit ($6,000) in a traditional IRA with an average annual return of 10% can build a nest egg worth nearly $1 million over 30 years.

Small business owners and self-employed workers may want to investigate other types of IRAs as well, like a SEP IRA plan.

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