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IRAs and 401(k)s are two different types of tax-friendly retirement accounts. While a 401(k) is an employer-sponsored plan, IRAs (individual retirement accounts) are available through investment brokerages, banks, credit unions and mutual fund providers. That means you can open one on your own and fund it as you like up to federal contribution limits.
IRA vs. 401(k)
These retirement accounts work a little differently, but they both allow you to set money aside for the future.
This is a tax-deferred retirement account that's provided through an employer. They establish the plan and allow employees to opt in. Contributions are typically made through automatic payroll deductions, and your employer might also match some or all of what you contribute.
The money you kick in is tax-deductible, so it reduces your taxable income today. You will, however, pay taxes on distributions you take in retirement.
There are several types of IRAs available. Traditional and Roth IRAs are among the most common.
- Traditional IRA: Contributions may be tax-deductible, and your money will grow tax-deferred. Like a 401(k), you won't pay taxes until you withdraw funds.
- Roth IRA: This type of IRA is funded with after-tax dollars, so you can withdraw your contributions at any time, tax-free. However, you may be taxed if you tap Roth IRA investment earnings before age 59½.
Can I Have Both an IRA and a 401(k)?
The short answer is yes—and here are a few reasons to consider it:
401(k)s and IRAs Have Different Contribution Limits
In 2023, you can contribute up to $22,500 to a 401(k) and $6,500 across all your IRAs. Folks who are 50 and older can make additional catch-up contributions of up to $1,000 for the most popular types of IRA. If you max out your 401(k), you could continue saving in an IRA.
Withdrawals May Be Taxed Differently
401(k) withdrawals count as taxable income, so you won't keep all of your savings. The size of your distributions could also push you into a higher tax bracket. Having a Roth IRA in the mix can provide a pool of tax-free money in retirement. That can help offset your tax burden when you're no longer working.
It Can Help You Avoid Early Withdrawal Penalties
Withdrawing money from a 401(k) or traditional IRA before age 59½ will usually trigger a 10% penalty—not so with a Roth IRA. You can make an early withdrawal of your contributions to a Roth IRA if you retire early or encounter a financial emergency. Importantly, this only applies to the money you deposited into the account, not the earnings that have accrued. This can provide some much-needed liquidity.
You Might Avoid Required Minimum Distributions
In 2023, you must begin taking distributions from tax-deferred retirement accounts at age 73. The age will bump up to 75 in 2033. Required distribution rules apply to 401(k)s, traditional IRAs and inherited Roth IRAs. Regular Roth IRAs are exempt.
Pros and Cons of 401(k)s
- Higher contribution limits: This allows you to save more. You'll also get a tax break on the money you put in.
- Tax-deductible contributions: This brings down your taxable income during your working years.
- Tax-deferred growth: You won't pay taxes until you withdraw funds.
- Potential employer match: This is essentially free money for retirement.
- Taxes can eat into your retirement income: When making your retirement income plan, you'll need to factor in the tax liability of 401(k) withdrawals. This could be significant if you withdraw a lot or are in a higher tax bracket in retirement.
- Early withdrawal penalties: Taking money out prior to age 59½ will likely result in a 10% penalty.
- Required minimum distributions: You must begin taking distributions at age 73. Otherwise, you may be hit with an IRS penalty equal to 25% of the amount not taken.
Pros and Cons of IRAs
- Another way to save for retirement: Funds you invest in an IRA can grow over time and help top off your nest egg.
- Tax benefits: Traditional and Roth IRAs provide unique tax advantages. Some are beneficial during your working years, while others come in handy during retirement. A Roth IRA, for example, can make you less dependent on a 401(k) for retirement income. You might take smaller 401(k) distributions—and have a lower tax bill in retirement as a result.
- Early withdrawal penalties and required distribution rules may not apply: Roth IRAs are typically exempt from rules that require you to take distributions at a certain age. You also won't be penalized for withdrawing your contributions ahead of retirement.
- Lower contribution limits: You can contribute significantly more to a 401(k). Saving solely through an IRA probably won't be enough to fund your whole retirement.
- Contributions may not be tax-deductible: Traditional IRA contributions might not be tax-deductible if you or your spouse have a 401(k). In some cases, the deductible amount might be reduced. Roth IRA contributions never reduce your taxable income, regardless of whether you have a 401(k).
- Early withdrawal penalties and required minimum distributions apply to traditional IRAs: The IRS usually tacks on a 10% penalty for early withdrawals. Distributions are also required at a certain age.
Is It Better to Have an IRA or 401(k)?
Neither an IRA nor a 401(k) is universally better or worse than the other: Both provide tax-efficient ways to save for retirement. Each offers its own perks and drawbacks, so what's right for you will depend on your unique financial situation. If you're torn between a 401(k) or IRA, you might consider having both. The following questions can help bring things into focus:
- Does your employer offer a 401(k)? If so, you might consider opting in. Talk to your benefits team to get more information about signing up.
- Is there an employer match? What's the minimum amount you'd have to contribute to get it? Your employer may match anywhere from 3% to 5% of your pay. It's wise to kick in at least enough to secure a match.
- Do you have extra funds to contribute to an IRA? If you're chugging along with 401(k) contributions and have room in your budget for more, you might put some cash into an IRA. The sooner you begin, the more time your money will have to benefit from compound interest. A Roth IRA might be a nice complement to your 401(k).
The Bottom Line
If you've got extra money to put toward retirement each month, an IRA could be a great way to build your savings on top of a 401(k). Both accounts have attractive tax perks. Just be sure you're contributing enough to your 401(k) to get an employer match.
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