IRA vs. 401(k): How To Choose the Right Account

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Both IRAs and 401(k) plans offer a way to save on taxes while saving for retirement. But choosing between each account requires learning a bit more about how each account functions — and how they can fit into your financial goals.

Although both types of retirement accounts offer tax benefits and allow flexible contributions, they are structured differently. An IRA is an individual plan, which makes it a good choice for self-employed, part-time or contract workers. A 401(k) is an employer-sponsored plan that you can access through your workplace. Read on to learn more about IRAs vs. 401(k) accounts.

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What Is an IRA?

There are many different types of IRAs, but they are all individual retirement accounts. This means they are established by individuals, rather than companies. However, small businesses can operate IRAs as well, such as in the form of a SEP-IRA or SIMPLE IRA. If a business opens an IRA, it must open individual accounts for all eligible employees as well.

All IRAs are tax-advantaged savings accounts, but some allow tax deductions on contributions while others allow tax-free distributions.

IRAs offer several key advantages that appeal to certain investors:

• You have more control over an IRA because you own the account.
• You get to keep an IRA even if you change jobs.
• You can invest your money in a variety of stocks, bonds, mutual funds and exchange-traded funds.

What Is a 401(k)?

A 401(k) is a company-sponsored retirement plan that allows salary deferral contributions, meaning money goes into the account on a pre-tax basis. Money is typically invested across a variety of mutual funds, ETFs or other investments. Earnings grow tax-deferred until retirement, when distributions become fully taxable.

Although you don’t have as much control over a 401(k), that doesn’t mean you should automatically opt out of your employer’s plan.

If your employer offers a 401(k) match, you should take advantage of it. This match automatically increases your savings.

Say, for example, your employer matches 100% of your 401(k) contributions up to 3% of your salary. If you make $50,000 and contribute 3%, or $1,500, to your account, your employer will add an additional $1,500 to your account.

Your money is yours right from the start. Your employer’s match becomes yours once you’re vested, which typically happens over a period of several years. That’s $3,000 in your retirement account, and you only paid half of it. Ignoring this perk is throwing away money.

Another key advantage of a 401(k) is the high contribution limit — $23,000 vs. $7,000 for an IRA.

Key Differences Between IRAs and 401(k) Accounts

Here is an overview to help you quickly compare an IRA vs. Roth IRA vs. 401(k) accounts.

How Do Tax Benefits Compare?

You contribute to both an IRA and a 401(k) with pretax money. With a 401(k), contributions come from your pay before taxes are taken out. With a traditional IRA, you contribute pretax income, and then deduct your contribution at tax time, up to certain income limits.

Having taxes deferred upfront with a 401(k) can allow you to invest more money sooner. This makes it possible to earn a greater return on your investment.

You can also choose a Roth IRA or Roth 401(k), which doesn’t save on taxes now, but allows tax-free withdrawals at retirement. This gives you an advantage if you think your income tax rate will be higher in retirement.

Which Offers Better Flexibility?

IRAs offer you more control over your investment options than a 401(k) allows. In a typical 401(k) plan, you’re limited to the investment choices that your employer’s plan offers. These investments may also come with high fees.

In an IRA, you’re generally free to invest in nearly any investment offered by your broker. You can choose higher growth options with an IRA if your goal is to maximize your money and you have a high tolerance for risk.

For 2024, you can contribute up to $23,000 to a 401(k). The allowable IRA contribution limit is just $7,000. Once you reach age 50, the IRS allows catch-up contributions for both IRAs at $1,000 and 401(k) accounts at $7,500. If you still need to save a lot for retirement, the 401(k) offers a clear advantage.

IRA vs. 401(k): Which Has Lower Fees?

The 401(k) mutual funds in which you invest carry an expense ratio that can eat away at your investment value over time. In an IRA, you might pay commissions for any investments you buy or sell, such as stocks.

You might also have to pay a fee to maintain an IRA at certain financial institutions. Fees are less dependent on whether you have an IRA or a 401(k) than on where you invest. Calculate fees as part of determining the total growth potential of your investment.

How To Maximize Employer 401(k) Contributions

An IRA is no match for a typical 401(k) when it comes to employer contributions. An IRA does not come with an employer-match program, but with the standard 401(k), your employer is allowed to match a certain percentage of the amount you contribute each year. This benefit can increase your rate of growth exponentially, and it’s one of the most rapid ways to grow your retirement money.

IRA vs. 401(k): What Works Best for Different Life Stages

A 401(k) plan is typically a better choice than an IRA no matter which life stage you’re at, because it offers an employer match and has a higher maximum. But this also makes it particularly suited to high earners. And as peak earnings typically come in your 50s, this makes a 401(k) an especially good choice for older savers, especially for those that can capture the massive $7,500 catch-up contribution after age 50.

Younger investors can benefit from the tax provisions of a Roth IRA for two primary reasons:

• Younger investors typically aren’t in the top tax brackets, which is when the tax deduction for traditional IRA and 401(k) plan contributions reap the biggest benefit.
• They have a longer time to build up the contributions and earnings in their account that will benefit from tax-free withdrawals in retirement.

IRA and 401(k) Together: Can You Open Both?

Yes, there are no restrictions to opening both an IRA and a 401(k) account. However, you must be mindful of the qualification and contribution requirements that apply to each.

If you are opening both accounts, Fidelity recommends that you contribute to your 401(k) plan up to the full amount of your employer match, then contribute to your IRA. If you can fully fund your IRA and still have more money to set aside, then go back to your 401(k) and contribute up to the maximum allowable, if possible.

Good To Know

A Savings Incentive Match Plan for Employees IRA is another type of retirement account. It’s available to small businesses with up to 100 employees.

Employers offering a SIMPLE IRA must contribute a minimum of 2% of each employee’s salary to the employee’s retirement account. Employees have the option to contribute and are always 100% vested in the plan.

How To Open a 401(k) Account

To open a 401(k) account, you’ll need to contact your human resources department at your workplace to ask about retirement accounts. If your work offers a 401(k) account, you can ask about enrolling in the plan.

Enrollment may include filling out the following:

• Your investment preferences
• Contribution amount which is typically a percentage of your paycheck
• Details of any company match that is included

After filling out the enrollment form, it may take a few paycheck cycles to kick in. Once you’ve enrolled in your workplace 401(k) plan, contributions will be automatically deducted from your paycheck.

How To Open an IRA

To open an IRA, you’ll first need to pick a trusted broker that offers IRAs. Reputable brokers like Vanguard, Fidelity and Schwab don’t charge fees to open an IRA and offer access to stocks, bonds, ETF and mutual funds with low costs.

After choosing a broker, you’ll need to create an account online and choose what type of account you wish to open. You’ll then fill out an application — which will feel similar to opening a bank account — by providing personal and financial information.

After completing the application, you’ll need to choose how to fund your IRA which typically involves linking your bank account. Once the account is open, you can choose to fund the account or set up recurring investments on a regular schedule.

Good To Know

It’s important to actually invest your contributions. Many brokers require you to deposit first and then choose your investments after. If you don’t choose investments within your IRA, the funds will sit in your account and only earn a nominal interest rate — which can severely hurt your retirement.

Jacob Wade contributed to the reporting for this article.

This article has been updated with additional reporting since its original publication.

This article originally appeared on GOBankingRates.com: IRA vs. 401(k): How To Choose the Right Account