Both individual retirement accounts (IRAs) and 401(k)s are types of tax-advantaged investment accounts individuals use to save for retirement. But they aren’t interchangeable. Find out the differences between these two valuable retirement accounts and the advantages and disadvantages of each.
IRAs and 401(k)s are the two main types of retirement accounts in the US. More than 60 million active participants and former employees and retirees held a 401(k) as of September 2022, according to the Investment Company Institute (ICI). Meanwhile, more than four in 10 US households owned an IRA.
Both types of accounts are tax-advantaged, meaning they offer tax benefits for setting aside money for retirement. The main difference between these two types of retirement accounts are:
| 401(k) | Roth IRA | Traditional IRA | |
|---|---|---|---|
| Who it’s for | You want to take advantage of employer-matching contributions You want to pay taxes on a smaller portion of your salary since your contributions lower your taxable income You want to invest passively through automatic elective-deferral contributions You’ve maxed out your IRA | You’re under the income limit threshold to save in a Roth IRA You think you’ll be in a higher income tax bracket in retirement You don’t want mandatory withdrawals at age 72 | You earn more today and think you’ll be in a lower tax bracket in retirement You make too much money for a Roth IRA You want an immediate tax break |
| Max contribution per year | $22,500 ($30,000 if you’re age 50 or older) | $6,500 ($7,500 if you’re age 50 or older) | $6,500 ($7,500 if you’re age 50 or older) |
| Are contributions tax-deductible? | No, you can’t take a deduction on your tax return, but your contributions automatically lower your taxable income | No | Yes |
An IRA is a tax-advantaged investment account individuals can use to save for retirement. Congress created the IRA in 1974 to provide workers without an employer-sponsored retirement plan with a means to set aside money for retirement.
Unlike the 401(k), individuals open IRAs on their own. They come in several types, but the two most common are the traditional IRA and Roth IRA. Most major banks and brokerages offer these retirement accounts, and anyone with earned income can open one.
Compared to a 401(k), IRAs let you invest in most assets. These include:
Through a self-directed IRA, which offers even greater flexibility in terms of permitted investments, you can invest your retirement funds in alternative assets. Examples of alternative assets include real estate, cryptocurrencies and commodities like physical gold.
IRAs come in two main types: traditional and Roth. Other types of IRAs include SEP and SIMPLE IRAs, though these are facilitated by business owners.
You can have a traditional IRA, a Roth IRA, or both, but your total contributions across both are capped at $6,500 in 2023.
Traditional IRAs are funded with pre-tax dollars, and contributions to this type of account are typically tax-deductible. The amount you can deduct depends on whether you or your spouse participates in a retirement plan at work. Come retirement, you pay taxes on both your contributions and the earnings on your investments.
Traditional IRAs have no income limits, but, like traditional 401(k)s, they do have RMDs. You’re required to begin taking distributions from your IRA when you reach age 72 (73 if you reach age 72 after December 31, 2022).
Contributions made to a Roth IRA are made with after-tax dollars, and contributions to this type of account are not tax-deductible.
However, since you already paid taxes on the money, you can withdraw your contributions at any time without taxes or penalties. And when you take qualified distributions of earnings from your Roth IRA, you do not have to pay taxes on the withdrawals. Aside from certain exceptions, a distribution is considered qualified when you reach the age of 59 and a half and have held your Roth IRA for at least five years.
Roth IRAs do not have RMDs, so you’re not required to make withdrawals at any point.
In 2023, you can contribute up to $6,500 ($7,500 if you’re 50 or older) total across both your traditional and Roth IRAs.
While traditional IRAs have no income limits, you’re limited to how much you can contribute (or if you can contribute at all) to a Roth IRA based on your modified adjusted gross income. For example, married couples filing jointly with a MAGI above $218,000 can’t contribute anything to a Roth IRA.
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A 401(k) is a retirement plan employers offer that qualifies for tax breaks under the Internal Revenue Code (IRC).
Employees contribute to a 401(k) via elective deferral, meaning a percentage of their salary is withheld and contributed to the account each pay period. Employers can also contribute to employees’ accounts. According to the Investment Company Institute, ninety-one percent of 401(k) plan participants are in plans with employer contributions. Employees then direct the money in their account into various available investments, most of which are mutual funds.
There are two types of 401(k) accounts: traditional 401(k)s and Roth 401(k)s. It’s possible to split your contributions between both, but the maximum you can contribute is $22,500 for 2023 ($30,000 if you’re age 50 or older).
The two most common types of 401(k)s are traditional and Roth 401(k)s. However, there are also safe harbor 401(k)s, SIMPLE 401(k)s and solo 401(k)s.
Here’s more on the two most common types.
Traditional 401(k) contributions are made using pre-tax dollars. While you don’t claim a tax deduction for your 401(k) contributions when you file your taxes, your contributions reduce your overall tax liability at the end of the year.
Your contributions and any earnings from your investments are tax-deferred. That means you pay taxes on contributions and earnings when you withdraw money at retirement. You can begin withdrawing money from your 401(k) without penalty once you reach age 59 and a half. Distributions before the age of 59 and a half will incur a 10% early-withdrawal penalty.
Traditional 401(k)s also have required minimum distributions (RMDs). With a traditional 401(k), you are required to start taking distributions when you reach the age of 72. The SECURE 2.0 Act, signed into law in late-2022, raised this age to 73 if you reach age 72 after December 31, 2022.
A Roth 401(k) is similar to a traditional 401(k), but employee contributions are not tax-deferred. They’re made with after-tax dollars — money you’ve already paid taxes on. Because of this, you can withdraw contributions at any time, tax- and penalty-free. Meanwhile, you can withdraw the earnings you’ve made on your investments tax-free after the age of 59 and a half.
Unlike employee contributions to a Roth 401(k), employer matching contributions are made with pre-tax money and are held in a traditional 401(k).
Employees can contribute up to $22,500 ($30,000 if you’re age 50 or older) per year to their 401(k)s. Employee contributions to a traditional 401(k) are made with pre-tax dollars, while contributions to Roth 401(k)s are made with post-tax funds.
Many employers offer matching contributions for their employees’ 401(k)s. These are often dollar-for-dollar matches up to a certain percentage of your salary. For example, your employer may match 100% of your contributions up to, say, 3% of your salary. If you make $50,000 per year and contribute $1,500 (3% of $50,000) to your 401(k), your employer would also contribute $1,500 on your behalf.
The 401(k) contribution limit is $66,000 for combined employee and employer contributions.
Qualified distributions from a 401(k) are allowed after you reach the age of 59 and a half. Distributions from a traditional 401(k) will be subject to federal income tax, while Roth 401(k) distributions will be tax-free, provided you’ve held the Roth 401(k) for at least five years.
If you take a distribution from either 401(k) type before you’re 59 and a half years old, you’ll have to pay an additional 10% penalty. There are some exceptions to this rule, including if you become totally and permanently disabled or if you need the money to prevent eviction. If you withdraw funds from a Roth 401(k) before the age of 59 and a half and before you’ve held the account for at least five years, you’ll have to pay both income taxes and the 10% early-withdrawal penalty.
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