IRA vs. 401(k): What's the difference?

The three most common types of retirement investment accounts are a 401(k), traditional IRA and Roth IRA.

Tags: Investing, Planning, Retirement
Published: March 04, 2021

If you’re eligible, it’s possible you could contribute to a 401(k) and a traditional and Roth IRA, so it may be helpful to know how they compare from a contribution, withdrawal and tax perspective. Here’s a look at their similarities and differences.

 

IRA and 401(k) definitions

A 401(k) is a type of employer-sponsored retirement plan. Depending on the industry you work in, your employer-sponsored retirement plan may be called a 403(b) or 457.

An IRA is an individual retirement account that you open with a financial institution, either a bank or a brokerage firm. Types of IRAs available include traditional IRAs, Roth IRAs and even options for self-employed individuals and small business owners.

 

IRA and 401(k) contributions and investment selections

There’s a difference in how you fund 401(k)s and traditional/Roth IRAs, as well as the investment options available to you.

 

401(k) vs. Traditional & Roth IRA
Eligibility
   
 

401(k)

Most employers have certain qualifications you must meet to participate in their retirement plan, such as being at least 21 and employed with the organization for at least one year.

 

Traditional + Roth IRA

Most people are eligible to open and contribute to an IRA.

For a traditional IRA, you need to have compensation.

For a Roth IRA, you must meet certain contribution criteria and tax filing requirements. Read more about IRAs.

Contribution details
   
 

401(k)

Contributions are directly withdrawn from your paycheck with pre-tax dollars.

Traditional + Roth IRA

Roth IRAs are funded with after-tax dollars. Traditional IRAs can be funded with after-tax dollars or as tax-deductible contributions.

Annual contribution limit
   
 

401(k)

$20,500 per year. If you’re age 50 or older you can contribute an additional $6,500 for a total of $27,000 per year.

Traditional + Roth IRA

$6,000 per year. If you’re age 50 or older you can contribute an additional $1,000 for a total of $7,000 per year.

Employer match details
   

401(k)

Varies by employer, with an average match of 4.7%.1

Traditional + Roth IRA

None.

Investment selection
   
 

401(k)

Investment options are generally chosen by your employer; more than one type of portfolio may be offered.

Traditional + Roth IRA

You can choose what goes into your portfolio.

 

IRA and 401(k) taxes and withdrawals

401(k)s and traditional IRAs have more in common when it comes to tax benefits, distribution and withdrawal requirements. They’re considered tax-advantaged investment accounts, since contributions are either pre-tax or tax-deductible.

A Roth IRA is considered a tax-free investment account, since distributions and qualified withdrawals aren’t taxed.

 

401(k) & Traditional IRA vs. Roth IRA
Tax implications
   
 

401(k) + Traditional IRA

Pre-tax or tax-deductible contributions.

Withdrawals taxed as ordinary income.

 

Roth IRA

Non-deductible contributions.

Tax-free withdrawals on contributions; tax-free withdrawals on earnings if you’ve owned the account for five years. 

Tax penalties for early withdrawal
   
 

401(k) + Traditional IRA

10% penalty tax if withdrawn before age 59 ½, but certain exceptions may apply to your situation.

With a traditional IRA, qualifying exceptions include first-time homebuyers, college and medical expenses.

Roth IRA

If you are younger than 59 ½, you can withdraw up to $10,000 penalty-free to pay for qualified first-time home-buyer expenses, provided at least five tax years have passed since your initial contribution.

Other exceptions may apply to your situation.

Required minimum distributions (RMDs)
   
 

401(k) + Traditional IRA

After you reach age 72, you are required to withdraw a certain amount each year, calculated based on your age and the value of your accounts.

Roth IRA

No minimum distributions required during the Roth IRA account owner or spouse’s life. Read about distribution requirements for an inherited IRA.

 

Is an IRA or 401(k) better suited for your needs?

  • Consider a 401(k) if your employer offers a company match and prefer to contribute to an account with pre-tax dollars.
  • If your priority is to lower your taxable income, a traditional IRA can help with that. Whatever you contribute, your taxable income may be lowered by that amount.
  • If flexibility is a priority, consider a Roth IRA. With qualified tax-free withdrawals in retirement, no required withdrawals and the ability to withdraw your contributions at any time, Roth IRAs make cashing out easy. 

 

Diversifying your investments can lower your taxes now and into retirement. Learn more in this guide to tax diversification and investing.

 

1This Is the Average 401(k) Company Match. How Does Yours Stack Up?, Money.com, June 4, 2019.