401(k) vs. IRA: what’s the difference?
In this article, we’ll go over everything you need to know to make a well-informed decision between a Roth IRA/traditional IRA vs a 401(k)/Roth 401(k).
A 401(k) is one of the most common ways to save for retirement.
Anyone with income can open an IRA through a bank/online broker/personal broker/investment company and pay into it, saving and investing for the long term.
Both traditional and Roth 401(k)s and IRAs have their advantages and drawbacks.
A financial advisor can help take away the stress and pressure of planning for retirement.
What is a 401(k) and a Roth 401(k)?
Many American employers offer a 401(k) retirement savings plan, which is named after a section of the U.S. Internal Revenue Code.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) plans: traditional 401(k) plans and Roth 401(k) plans.
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 or 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, with nearly three-quarters (73%) of private employers offering this type of plan to their workforce. Actual take-up then tends to vary with age, with more than three-quarters (76%) of Gen X-ers saying they contribute to plans compared with less than half (47%) of Gen Z-ers.
When you have a 401(k), you are responsible for choosing your specific investments from a range of stocks, bonds, mutual funds, and target-date funds. There will also be contribution limits (which are impacted by inflation) to consider.
For 2024, the annual limit on employee contributions for workers under 50 was $23,000. For individuals aged 50 and over, an additional ‘catch-up’ contribution limit of $7,500 also exists.When it comes to a major financial issue such as retirement planning, it makes sense to speak to a financial advisor. Unbiased can help match you with a professional suited to your needs. Simply answer a few questions, and we’ll do the rest. Get started here.
What is an IRA and a Roth IRA?
Is an IRA a 401(k)? No. An IRA is an acronym for an individual retirement account, which is a separate retirement savings account.
Anyone with income can open an IRA through a bank, online brokerage, personal broker, or investment company and contribute to it, saving and investing for 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 can usually not be withdrawn before the age of 59 and a half 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
When choosing the right retirement savings account for you, consider the many benefits, drawbacks, and considerations for each option.
But how do they fare when compared with each other?
Here’s a list of pros and cons that explain the main advantages and disadvantages of IRAs, 401(k)s, et al.
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.
IRA/Roth IRA 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 an IRA before the age of 60.
The IRS generally requires distributions from an IRA to begin by age 72.
An IRA can create a task risk due to exposure.
401(k)/Roth 401(k) advantages
A 401(k) can increase 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 version reduce annual taxable income.
401(k) contributions are automated and easy to manage.
A 401(k) is federally protected and a good gateway into other investment options.
401(k)/Roth 401(k) 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 a limit is still applied.
IRA vs 401(k): which should I choose?
Getting ready for retirement is one of the biggest financial decisions that you’ll make. It’s best to get expert financial advice before making any big choices
A financial advisor can help you avoid the stress and pressure of making such a big life decision by providing expert, trusted advice.
Content Writer
Andrew Michael is a multiple award-winning financial journalist and editor whose work has appeared in numerous newspapers, magazines, and online platforms, including The Times, Evening Standard Money, Financial Times, Shares, and Forbes Advisor.