401(k) vs. IRA: what’s the difference? 

What is a 401(k) and Roth 401(k)?

Many American employers offer a 401(k) retirement savings plan. It’s named after a section of the U.S. Internal Revenue Code (IRC).

When a person has a 401(k), they have a company-sponsored retirement account. Their employer matches the contributions they make to this account. 

There are two basic types of 401(k) – traditional 401(k)s and Roth 401(k)s.

A traditional 401(k) is an account into which employee contributions are made pre-tax. This reduces the final amount of taxable income an employee earns each year, but withdrawals from the 401(k) are then taxed.

A Roth 401(k) is the opposite. Employee contributions are made after tax, and withdrawals are tax-free (because the tax has already been paid). 

401(k) owners and their employers contribute differently/at different times depending on whether it’s a traditional or Roth account.

Either way, a 401(k) is one of the most common ways to save for retirement – though only 41% of workers in the country currently contribute to a 401(k), even though 68% of workers have access to employer-sponsored plans. 

When you have a 401(k), you are responsible for choosing your specific investments from an assortment of stocks, bonds, mutual funds and target-date funds. There will also be contribution limits (which are impacted by inflation) to consider. 

For 2022, the annual limit on employee contributions for workers under 50 was $20,500, and employee-employer contributions couldn’t total more than $61,000.

Those over 50 could make a $6,500 catch-up contribution, with the limit of employee-employer contributions rising to $67,500. 

It’s wise to speak to a financial advisor when making big financial decisions. Unbiased can help match you with a financial advisor suited to your needs. Simply answer a few questions, and we’ll do the rest. Get started here.

What is an IRA and Roth IRA?

Is an IRA a 401(k)? No. An IRA is an acronym that stands for Individual Retirement Account.

Anyone with income can open an IRA through a bank/online brokerage/personal broker/investment company and pay into it, saving and investing in the long term.  

Unlike a 401(k), there’s no need to involve (or have) an employer when opening an IRA.

There are annual income limitations for deducted contributions, and money held in an IRA usually can’t be withdrawn before the age of 59½ without incurring a 10% tax penalty.

There are four main types of IRA: 

• A traditional IRA – Like a traditional 401(k), contributions are pre-tax, and withdrawals are taxed. 

• A Roth IRA – Like a Roth 401(k), contributions are taxed, but qualified distributions are tax-free. 

• A Simplified Employee Pension (SEP) IRA – Designed for self-employed individuals. 

• A Savings Incentive Match Plan for Employees (SIMPLE) IRA – Designed for self-employed individuals and small business owners. 

What about rolling over your 401(k) to a Roth IRA? To avoid 401(k) contribution limits, many people at some point choose to change their 401(k) into a Roth IRA.

This is called a Roth conversion, and it allows people to enjoy 401(k) benefits followed by Roth IRA benefits – the best of both worlds.  

It’s important to note that after a Roth conversion, you will owe tax on the money from your 401(k) if it was previously untaxed (but not if you’re transferring from a Roth 401(k) to a Roth IRA).

Plus, though you’ll be able to withdraw contributions, you won’t be able to withdraw earnings (interest and profits) from your Roth IRA for at least five years once you’ve transferred. 

Want to see your Roth IRA at retirement? Use our free Roth IRA Calculator>

Roth IRA or 401(k): the pros and cons

IRA vs 401(k). Roth 401(k) vs Roth IRA – benefits, drawbacks and things to consider apply to all of these retirement savings options.

But when compared to each other, how do they fare?

Here’s a pros and cons table that explains the key advantages and disadvantages of IRAs and 401(k)s... 

The IRA/Roth IRA

Advantages

• When you open an IRA, you can choose to invest in a wide range of financial products, including stocks, bonds, mutual funds and exchange-traded funds. 

• Self-directed IRAs allow designated third parties to make all your investment decisions for you. 

• IRAs come with significant tax deductions, and Roth IRAs benefit from tax-free growth. 

• IRAs are accessible and easy to set up. 

• There are no income limits applied to IRAs. 

Disadvantages

• There are contribution limits applied to IRAs. 

• If covered by a workplace retirement plan, tax deductibility is limited. 

• Penalties apply for money taken from the IRA before the age of 60. 

• The IRS generally requires distributions from an IRA to begin by the age of 72. 

• An IRA can create a task risk due to exposure. 

The 401(k)/Roth 401(k)

Advantages

• A 401(k) can double your retirement savings through employer matching. 

• 401(k) contributions can be used as loans in an emergency or financial crisis. 

• 401(k)s have some excellent income tax benefits, and contributions to a traditional 401(k) reduce annual taxable income. 

• 401(k) contributions are automated and easy to manage.  

• A 401(k) is federally protected and a great gateway into other investment options. 

Disadvantages

• 401(k)s require monitoring and management over time. 

• 401(k)s don’t come with much guidance and require owners to make investment selections. 

• There are early withdrawal penalties, potential waiting periods and high fees associated with 401(k)s. 

• 401(k)s aren’t very flexible and come with fewer investment options. 

• 401(k)s allow higher annual contributions than IRAs, but there is still a limit applied.