IRA vs. 401(k)

The money in an IRA is usually invested in stocks, bonds and other assets like mutual funds and CDs. Ideally, the money grows as stock market indexes increase over time and as dividends and interest payments add up. There are two types of IRAs, traditional and Roth, both of which have tax advantages.

You are eligible to contribute up to $6,500 to a traditional IRA in 2023 ($7,500 if you are age 50 and older). If you’re self-employed, you are eligible to open a Simplified Employee Pension (SEP) IRA and contribute up to 25% of your income with a limit of $66,000. Both a traditional IRA and a SEP are pre-tax accounts, which means that they are funded with money that has not yet been taxed. Taxes on contributions and earnings are deferred until you make withdrawals.

A Roth IRA is financed with after-tax dollars. Consequently, investors are only liable for taxes on interest, dividends, and capital gains accrued within the account. However, you can only contribute to a Roth IRA if your modified gross income in 2023 is less than $153,000 (when filing single) or $228,000 (when filing jointly).

Avoid withdrawing money from your IRA before age 59 1/2. You’ll incur a 10% early withdrawal tax penalty in most circumstances on those funds. Talk to a financial advisor or tax professional when making withdrawals to ensure you pay as little tax as possible.

There are both pros and cons to using an IRA as a retirement strategy. Weigh the following points when deciding whether to use one.

The 401(k) plan, another retirement savings option, is solely provided by employers that offer a plan — not all employers do. You can contribute to a 401(k) plan by transferring money to your plan or by making contributions directly from your paycheck. 

Some employers also match some or all of workers’ 401(k) contributions as an incentive to save for retirement. While you still get to make investment decisions about your money, 401(k) investments are usually limited to funds selected by your employer.

If your employer has a 401(k) plan, ask the human resources department to enroll you. You can then choose how much of your salary you’d like to contribute and which investments you’d like to buy with those funds. For the 2023 tax year, you can contribute a maximum of $22,500 to your 401(k) or $30,000 if age 50+.

You can deduct your 401(k) contributions from your federal income taxes, but you’ll pay ordinary income tax on your withdrawals later. State tax rules with respect to 401(k) contributions vary. If you contribute to a Roth 401(k), you will pay taxes on the funds you contribute, but you will not be taxed on money you withdraw during retirement.

You’ll usually face tax penalties for withdrawing money from your 401(k) before age 59 1/2. However, every plan has different rules and features depending on the company sponsoring it. Check the rules of your employer’s 401(k) plan and speak to your financial advisor to find out if there are restrictions you should be aware of.

Like IRAs, 401(k) plans also have benefits and drawbacks.

IRAs and 401(k)s have many similarities and differences. Your financial advisor can help you compare the two and decide which one makes the most sense for your needs, but here are some specifics about each retirement strategy.

When retirement planning, you have investment decisions to make. 401(k) plans are only available through an employer. If your employer offers one and matches contributions, you can take advantage of this to build a much larger nest egg than you could save on your own. However, you’ll be limited to the investment options your employer provides. You might also run into trouble if you change jobs often or if your employer isn’t financially stable.

In those situations, an IRA may be a better fit for your needs. While you’ll miss the benefit of employer matching and have a lower contribution ceiling, you’ll be able to choose your own investments. You’ll also have more ways to avoid paying the 10% early withdrawal tax if you need to withdraw some money before age 59 1/2.

Talk to your financial advisor about which of these two savings vehicles they recommend for your needs. They’ll advise you based on your financial profile.

With retirement savings options, there’s no one-size-fits-all solution. Roth IRAs and 401(k)s have advantages and disadvantages that make each the better choice in certain situations.

Which is right for you?

Consider the following:

Remember: It’s not always a choice between an IRA and a 401(k). Many people set up both accounts and reap the benefits of each.