401(k) Plans vs. Individual Retirement Accounts: How Do They Compare?

Saving for retirement is a key component of any personal finance plan. Both 401(k) and IRAs are tax- advantaged investment vehicles that enable you to put money away for the future. Making sure you understand how these two options compare can help you choose the right path for your retirement investments.

At their core, 401(k) plans and IRAs share a number of similarities. Most importantly, both of these options can serve as a smart way to help you save for retirement needs.

What is a 401(k) Plan?

A 401(k) plan is an employer offered, tax-advantaged retirement savings vehicle. Many employers offer 401(k)s as part of their benefit plans in order to incentivize prospective employees to come work for their firm. Employers will automatically deduct a portion of your paycheck (a percentage that you will determine) to contribute to your 401(k). Your employer will offer multiple investment tracks for you to choose from, which vary based on the amount of risk you are willing to absorb.

One of the biggest perks of 401(k) plans is the employer matching function. If your employer offers this benefit (they are not required to do so), this will allow you to significantly increase the amount you are putting towards your retirement.

For instance, if your employer offers a 100% matching benefit of up to 5%, every dollar that you contribute up to this amount will automatically double. In other words, if you decide to contribute 5% of your monthly salary to your plan, 10% of your overall salary will be invested (5% from you, 5% from the company).

Your tax benefits will either be incurred before or after your investment gains, depending on whether you have a Roth or Traditional 401(k) plan.

For Traditional 401(k) plans, the amount you contribute annually will be deducted from your tax obligations for that tax year. You will then pay taxes on the other side, as your benefits (also known as deductions) in retirement will be considered taxable income.

Roth 401(k) plans, on the other hand, do not offer a tax break in the tax year in which you make your contributions. However, the monies in your Roth 401(k) plan will grow tax-free, and you will not incur tax obligations when you receive these payments later on.

You can experiment with TipRanks’ 401(k) retirement calculator to understand how different factors such as your contributions, employer match, and expected rate of return will affect the value of your 401(k) account over time.

What Are IRAs?

An IRA, or Individual Retirement Account, functions in almost the exact same way as a 401(k) plan. The biggest difference is that you will be responsible for setting up your investment account, not your employer.

Since IRAs are independent of your place of employment, you will not receive any contributions from the company where you work. (One exception to this rule is if you have a SEP-IRA, but this applies only to small businesses.) However, because you are responsible for setting up your IRA, you have more freedom to choose among different types of investment options than you would with a 401(k) plan, where your employer will define your choices for you.

Similarly to a 401(k) plan, an IRA comes in both Traditional and Roth frameworks. There are annual limits to your amount that you can contribute to an IRA. In 2024, the maximum contribution is $7,000 (though the number rises to $8,000 if you are over the age of 50).

For Roth IRAs, the maximum contributions you can make every year start to taper off and eventually reach zero if you make more than a specific amount of income. If you are earning above this level, you will not be able to directly contribute to a Roth IRA. The IRS publishes these numbers and limits on its website.

For Traditional IRAs, there is no such income limit.

How Do 401(k) Plans Compare with IRAs?

Though they share a common denominator, there are distinctions between these two different types of tax-advantaged investment vehicles.

As explained above, the most significant difference is that 401(k) plans are provided through your employer, and often have an employer match component. With an IRA, you are on your own.

The other major difference is the maximum amount that you can contribute on an annual basis. 401(k) plans are capped at $23,000 a year, which is a significantly higher ceiling than what exists with IRAs.

Choosing Between a 401(k) Plan and an IRA

If you are fortunate enough to be in a position to choose between opening up a 401(k) plan or an IRA, the general consensus is that you should start with your 401(k) plan in order to maximize your employer contributions.

If your employer offers a 5% match, for instance, first and foremost you should prioritize making at least a 5% contribution in order to receive these funds from your employer.

Once you have maximized your 401(k) contributions (and you are still in a position to contribute to other retirement savings accounts) then it could make sense to consider opening up an IRA. This is because IRAs offer slightly greater amounts of flexibility in terms of your investment choices. The downside, of course, in opening another investment plan is that this will require you to manage–even passively–more than one retirement account.

Conclusion: Saving for the Future

Balancing your current spending needs with your future goals is one of the key tenets of personal finance. Navigating this tension requires being intentional with your present day consumption, while dedicating specific funds every month to your retirement account.

Both 401(k) plans and IRAs can be set up so that monies are automatically deducted from either your paycheck or a savings account at set intervals. Implementing this type of system will force you to put money aside on a regular basis during your working years.

Doing so throughout your career can help you to be financially comfortable once you do reach your golden years.

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