Today, investors commonly have access to two retirement savings accounts: an IRA and an employer-sponsored account, the most common of which is a 401(k). Choosing or utilizing both accounts is a strategic decision on your path to financial freedom. Knowing the differences of these accounts and how to leverage them best can help you maximize your savings and help you grow your nest egg over time.

Similarities Between an IRA and 401(k)

The Individual Retirement Account (IRA) and 401(k) were both created under the Employee Retirement Income Security Act of 1974 (ERISA). Their shared goals were to encourage investors to save for retirement by offering tax advantages. Some similarities between these two accounts include:

Tax advantages: Both IRAs and 401(k)s offer tax benefits, whether you opt for a Traditional or Roth account. In a Traditional IRA or 401(k), your investments grow tax-deferred, while in a Roth version, they grow tax-free. These two types of accounts are exempt from capital gains tax, a benefit most standard brokerage accounts don’t provide investors. Investors can also reduce their taxable income when contributing to a Traditional IRA or 401(k), which can benefit high-earners.

Account availability: IRA and 401(k) accounts are offered as Traditional and Roth options. The former means that contributions are made with pre-tax income, while the latter is made with post-tax contributions. The similar availability of these accounts makes it easy to leave a job and roll over your existing 401(k) to a similarly taxed IRA.

Distribution implications: IRA and 401(k) accounts have similar distribution rules. Investors must wait until 59 ½ to distribute funds without penalty, true for both Roth and Traditional IRA accounts. If you take a distribution of funds before 59 ½, a 10% additional penalty applies to distributions from Traditional accounts and earnings from Roth accounts. Keep in mind that investors can withdraw Roth contributions at any time tax and penalty-free since you already paid income taxes. There are several exceptions to the 10% penalty, which apply to both IRA and 401(k) accounts. Other distribution implications include the Roth five-year rule and Traditional IRA Required Minimum Distributions (RMDs).

Differences Between an IRA and 401(k)

While these accounts share several features, they also have notable differences in contribution limits, investment options, and accessibility.

Contribution limits: The contribution limits differ significantly between IRAs and 401(k)s. 401(k)s typically have much higher contribution limits than IRAs. These are typically updated by the IRS annually. Visit the IRS website to view current contribution limits.

For self-employed individuals, SEP IRAs and SIMPLE IRAs offer higher limits.

Investment choices: 401(k) plans typically have fewer investment choices than IRAs. Within 401(k) accounts, investors can choose between various mutual funds, many of which track broad market indices. On the other hand, IRAs provide access to various investment options, including stocks, mutual funds, ETFs, and financial derivatives based on the investor’s sophistication.

Account access: Individual investors can open an IRA account by signing up for an account online. Only employers can open a 401(k) account for an employee as part of a workplace benefit. Since 401(k) accounts are a workplace benefit, many companies contribute to their employee’s accounts. IRAs don’t allow for employer contributions, meaning that the investor must make all IRA contributions directly.

Income limits: Although there is no defined income limit on being eligible to contribute to your 401(k), the IRS institutes limits on employer’s matching contributions.

Traditional IRAs are not subject to income limits, but your ability to deduct contributions may be limited based on your income. If you are covered by an employer’s retirement plan and contribute to your Traditional IRA, additional deduction rules set by the IRS may apply to you.

Liquidity needs: Some 401(k) plans can provide loans, where the capital is paid back into your 401(k) at a certain interest rate. IRAs do not offer loans; however, both types of accounts allow certain withdrawal exceptions to access funds without a 10% penalty.

Key Considerations for Contributing to IRAs and 401(k)

For many people, it’s possible to contribute to both an IRA and 401(k) to maximize retirement savings.

Whether your employer has a program to match 401(k) contributions would likely impact your strategy. If your employer matches your 401(k) contribution, it’s common for investors to first contribute up to their employer’s matching limit before maxing out their IRA. If any money is left over to invest, many investors return to their 401(k) until it’s maxed out.

However, if your employer does not match your 401(k) contribution, investors may max out their IRA before contributing to their 401(k).

Risks of IRAs and 401(k)s

While IRAs and 401(k)s offer significant advantages for retirement planning, they come with risks that investors should carefully consider. Early withdrawals from these accounts—before age 59 ½—can trigger a 10% penalty in addition to ordinary income taxes, unless specific exceptions apply, such as disability or first-time home purchases.

For Roth accounts, withdrawing earnings before meeting the five-year rule may also result in taxes and penalties. Additionally, loans from 401(k)s, while offering short-term liquidity, must be repaid within specific timeframes to avoid being treated as taxable distributions.

Another risk is market volatility, as investments within these accounts, such as mutual funds, stocks, or ETFs, are subject to fluctuations, potentially leading to losses.

Furthermore, employer matching contributions in 401(k)s may be subject to vesting schedules, meaning employees could lose access to these funds if they leave their job before fully vesting.

Finally, required minimum distributions (RMDs) for Traditional IRAs and 401(k)s, starting at age 73 as of 2023, can increase taxable income in retirement and may impact financial planning if not anticipated.

The Bottom Line

The choices you make when investing in your IRA and 401(k) will impact how you save for retirement over your working years.

Understanding the differences, and how you may be able to benefit from both account types is a critical step in preparing for retirement.

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