IRA vs. 401(k): What Are the Differences and Which One Is Better?

When choosing a retirement savings account, the two most common plans to consider and compare are an IRA vs. 401(k). Depending on your investment plans, you may choose to utilize one over the other — or a blend of both. Regardless, it is good to be aware of each accounts’ benefits to help you reach your goal of having enough money to live comfortably in your retirement years.

Let’s take a look at the differences between the plans and which one might be the best option for you.

What is an (IRA)?

Most brokerages or financial institutions that provide retirement plans can help you open an IRA. However, before you start your account, you’ll want to first pick which form of IRA you want. There are four basic types of accounts: traditional IRAs, Roth IRAs, SEP IRAs and SIMPLE IRAs. By discussing your specific needs with a certified tax consultant, they will help you make the most informed decision. Here are some things to consider:

  • Traditional IRA contributions are typically tax deductible; they are often referred to as “pre-tax” contributions. Taxation on these accounts occurs when you make a withdrawal.
  • Roth IRA contributions are made with after-tax earnings. This means you won’t get a tax break in the year you make the contribution. Once you retire, however, eligible Roth IRA withdrawals are tax-free.
  • A SEP IRA is a type of IRA in which ONLY the employer contributes to the account. While most businesses can use this as a retirement plan, mainly small business owners or self-employed individuals usually select this option because of cost.
  • Through a SIMPLE IRA both employees AND employers can contribute to traditional IRAs. Businesses with less than 100 employees can use this plan. A SIMPLE IRA cannot be a Roth IRA.

What is a 401(k)?

If your employer offers you a traditional 401(k) account as a retirement savings option, and you elect to participate, contributions to your account will come as deductions as a percentage of every paycheck. Those contributions will be made prior to calculating tax, or pre-tax dollars. That money is set aside specifically for you into an investment account. On occasion, some companies may even match your contributions depending on the contribution limits.

Roth 401(k)s are also available and a bit different. Your contributions are not tax-deductible and are made after-tax dollars. However, eligible withdrawals are often tax-free. (Some conditions apply.)

IRA vs. 401(k):

Here are a few points to consider when opening either an IRA or a 401(k):

IRA

  • Annual contribution limits for traditional and Roth IRAs are $6,000 as of 2021 and 2022, with an additional $1,000 catch-up contribution allowed for people ages 50 and older.
  • Like 401(k)s, contributions to traditional IRAs are generally tax-deductible.
  • Contributions to a Roth IRA are made with after-tax dollars, meaning you don’t receive a tax deduction in the year of the contribution.

401(k)

  • The contribution limit for 2022 are increasing to $20,500 annually, with an additional $6,500 catch-up contribution allowed for people ages 50 and older.
  • Some employers may match a percentage of their employees’ contributions up to a certain limit annually.
  • Withdrawals are taxed at your income tax rate, and there’s no penalty for withdrawals as long as you are 59½ or older.

IRA vs. 401(k): Which one is better?

If your company matches your 401(k) contributions and you only have the money to fund one account, the difference between an IRA and a 401(k) may be clear: the 401(k) could give you a larger investment for the same cost.

There’s no reason to stop there, though. If your salary allows you to contribute a larger amount to your 401(k) while also contributing a smaller amount to your IRA, you could consider investing in both.

In conclusion, the best option for you will depend on your own status and financial circumstances. But don’t let your fear of investing keep you from starting. Simply choose an investing strategy and watch your retirement balance grow.

If you want to learn more about creating the best possible 401(k) plan for your company at no cost contact SaveDay today.