401(k) vs. IRA: How to decide

If you're considered contributing to a retirement account, you may be overwhelmed with the options. This article will provide a guide path to your retirement future and help you navigate the waters. We’ll talk about the similarities and differences between 401(k)s and IRAs as well as which to invest in if you don't want to max out both.

The IRA and 401(k) share some basic similarities. Both are types of investment accounts designed to help you save and invest money for your retirement. While the money is in the account, the investments within grow and compound tax-free. However, early withdrawals are penalized, except under certain circumstances.

So, how much should you put in an IRA vs. a 401(k)? We'll walk you through the difference between these two types of accounts (and their sub-types) so you can figure out the best place to put your savings.

How does an IRA work? Roth vs. Traditional?

Keep in mind that an IRA—an individual retirement account—can be set up and contributed to on your own. A 401(k) is an employer-sponsored retirement savings plan. So if you are a freelancer, unemployed, or your current company does not offer a 401(k), then an IRA is your only option.

There are two common types of IRA accounts: Traditional IRA and a Roth IRA. Both accounts allow your money to grow tax free. Both traditional and Roth IRAs have some similarities:

• Both accounts have an annual contribution limit of $7,000 for 2024 ($8,000 for those over age 50).

• Account owners can invest in most types of stock, bond, and cash investments, including mutual funds, exchange-traded funds (ETFs), and individual stocks and bonds within the account.

A Roth IRA contribution is made with after-tax dollars . Roth IRA eligibility phases out at annual income of $161,000 for single filers. The phase-out starts out at $240,000 for married filers. The Roth IRA retirement account has certain benefits that are lacking in the other retirement choices:

• There is no required minimum distribution. You never have to withdraw the money and can pass the account on to your heirs.

• As long as you are older than 59 ½ or meet the required other requirements, the withdrawals from the account are tax-free.

A traditional IRA contribution is made with pre-tax dollars. Contributions to  traditional IRA accounts may or may not be tax-deductible. If you (and your spouse) are not covered by a workplace retirement plan, then your contributions into the plan are deducted from your taxable income.

Your income level also impacts whether your IRA contribution is deductible or not. Although money held within the traditional IRA can grow tax free, there are other stipulations attached to this type of account. For example, account owners must begin taxable required minimum withdrawals (RMD) from the IRA at age 70 ½.

Related articles:

• How to open a Roth IRA

• How does a Roth IRA grow & earn interest?

• All about Roth IRAs

The following chart lays out the basic characteristics of the traditional IRA vs Roth accounts :

How does a 401(k) work?

A 401(k) is another type of retirement account, created by your employer for the employee’s benefit. Eligible employees have the opportunity to contribute a portion of their salary into the 401(k) account. The amount of your employee contribution reduces your taxable income. In many cases, employers also offer a company match, in which the employer matches a portion of the employee’s contribution into the account. This is often considered “free money” because the contributions are made by the plan sponsor directly into your account.

A great benefit of the 401(k) over the IRA is the higher contribution limit — employees can contribute up to $23,000 per year into their account in 2024 with a catch-up contribution of $7,500 for those over age 50. Add in the employer’s matching contribution and this is a powerful retirement savings vehicle.

More about 401(k)s:

• 401(k) basics for your first job

• 6 Important 401(k) Mistakes to Avoid

• How and Why to Change Your 401(k) Setup Percentages

• Is a 401(k) Match Tax Deductible?

• Solo 401(k)s: A Plan for Those Who are Self-Employed

401(k) vs. IRA: How do they compare?

Now that you understand the basics of each type of account, let’s talk comparisons. Here’s a quick glance at the key differences between the details of an IRA and 401(k):

Which account should I choose? 

First, if there’s an employer match, you should consider investing in the 401(k) the amount necessary to receive the full employer contributions. You don’t want to ignore free employer money. 

From there, it becomes a matter of choice. Compare the investment options and cost of the IRA you are interested in to those of the 401(k) plan and determine which one makes the most sense for you.  

Can I contribute to both a 401(k) and an IRA?

There’s no easy answer to this question. Consider your options and strive to invest in both if you meet the eligibility guidelines and your personal finances allow it. If not, weigh the advantages and disadvantages of each type of account.