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IRA vs. 401(k): What Every Retirement Investor Should Know

Nov 29, 2021 3 min read Eric Rosenberg

Key takeaways

  • IRA and 401(k) accounts let you save for retirement with tax benefits.
  • Employers may match your contributions but limit your investment choices.
  • IRAs offer more control, flexibility and potentially lower fees.

 

If you want to save and invest for retirement, it’s wise to take advantage of accounts that offer tax benefits. Two popular examples are individual retirement accounts (IRAs) and workplace-sponsored 401(k) plans. Both let you choose from a menu of investments, offer tax breaks either when you contribute or withdraw money, and let your account grow tax deferred in the meantime. Both could also incur taxes and potential penalties if you withdraw your money before age 59½. But they also differ in some key ways.

Here are some basics on IRAs and 401(k)s—and how to take advantage of them.

 

 

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

Essentially, you open an IRA yourself at a financial institution of your choice. By contrast, 401(k) plans are available through employers. Similar to 401(k)s, 403(b)s—for nonprofit, education and health care workers—and 457s—for government workers—are also employer sponsored.

But there are other key differences to consider.

For example, as an incentive for you to save, your employer may match up to a certain percentage of the pay you contribute to your account. Workplace plans are often made easy to manage with simple online tools, but the investment options are limited. An IRA offers more investment flexibility but no match, and when it comes to managing your money, you might be on your own.

 

IRA advantages

An IRA’s biggest advantage over a 401(k) account is flexibility. You can open an IRA at most financial institutions, and the range of investments you can choose can be enormous. Also, if you leave your job, you can roll over money from 401(k)s and similar plans into IRA. (Some employers require that you take your money with you.)

These are several popular types of IRAs:

Traditional IRA

You fund this account with tax-deductible or pretax dollars. The account can grow tax deferred, but you’ll owe income tax on withdrawals (ideally in retirement when you're in a lower bracket).

However, depending on your income and tax filing status, you may not qualify to contribute to a traditional IRA. For instance, single taxpayers who are covered by a workplace retirement plan and earn over $78,000 do not qualify for this type of IRA.

 

Roth IRA

You contribute after-tax dollars, but withdrawals can be tax free. A Roth IRA can make sense if you don’t need a current tax break or expect your tax bracket to be higher when you withdraw than when you contribute.

This type of IRA also carries income limits and phaseouts. Single taxpayers and heads of household who earn more than $144,000 per year may not qualify. Those who earn between $129,00 and 144,000 may be submit to a lower contribution limit.

 

SIMPLE IRA

This plan enables small businesses and their employees to contribute pretax money to employees’ accounts. Like a traditional IRA, withdrawals are subject to income tax. Simple IRAs carry an income minimum—you must have earned at least $5,000 during any two preceding calendar years and expects to receive at least $5,000 during the current calendar year, although the IRS allows employers to use less restrictive participation requirements, but no more restrictive ones. An employer can eliminate or reduce the prior or current year compensation amounts.

 

SEP IRA

With a “Simplified Employee Pension,” small business owners and the self-employed make tax-deductible contributions to employees’ accounts. Withdrawals are taxable as regular income.

Employees must receive at least $650 (2022) in compensation from the employer during the year to be eligible to participate. An employer can use less restrictive participation requirements.

 

401(k) advantages

For many, the biggest benefit of a 401(k) plan (or 403(b) or 457) is an employer match—usually 3% to 6% of your pay. Essentially, it's money you've earned just for contributing to your account.

In addition, saving through a 401(k) is easy. Contributions are deducted from your paycheck and invested based on your choices. Some employers enroll you automatically—often on Day One. Features like automatic contribution increases make it effortless to save more as time passes. And while the plans' investment options are limited, they often include target-date funds that give you a diversified portfolio based on your age.

Also, many employers offer both traditional pretax and Roth after-tax options. If your employer offers a match, those funds will likely go to the traditional account.

 

Contribution limits for 2022

Account Regular Contribution Limit Age 50+ Extra "Catch-Up" Limit
Traditional or Roth IRA $6,000 $1,000
Simple IRA $14,000 $3,000
SEP IRA $61,000 (or up to 25% of your net earnings from self-employment) Not applicable; SEP IRAs do not allow catch-up contributions
401(k), 403(b) or 457 $20,500 $6,500

 

Is it better to have an IRA or a 401(k)?

IRA vs. 401(k)? The right answer for you depends on your income, retirement goals and other financial details.

401(k)s are a good idea for nearly any employee who can participate, especially if a match is available. IRAs are great for anyone who doesn’t have a retirement account through work. A spousal IRA allows working spouses to put aside retirement funds for a non-working spouse. Anyone who wants to save more outside work can also take advantage of an IRA.

 

Can you have a 401(k) and an IRA?

You aren’t limited to one type of retirement account. Many determined retirement savers contribute to both a 401(k) and an IRA. You can save up to the respective annual limit in each account, though tax benefits on IRA contributions might depend on your income level and other factors.

Indeed, having both a 401(k) and an IRA can help you avoid one of the biggest financial regrets people experience as they age: not having saved enough for retirement.

 

 

What you can do next

If you have a retirement plan at work, make sure you’re contributing at least enough to earn any match your employer offers—but save more if you can. If you don’t have a workplace plan—and maybe even if you do—open an IRA. If you have an old 401(k) plan, consider a rollover to an IRA. Review the pros and cons of traditional vs. Roth accounts to learn which may be best for you. And if you have questions, a financial professional can provide answers.

Footnotes

Eric Rosenberg is a finance, travel and technology writer in Ventura, Calif. He has in-depth experience writing about banking, credit cards and investing.

 

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