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The difference between an IRA and a 401(k)


By The Human Interest Team

Editorial Policy

Tax-advantaged accounts offer individuals significant incentives to invest in their retirement. If you want to open a retirement account and secure your nest egg, you can contribute to individual accounts, employer-sponsored plans, or both.

401(k) vs. IRA: An Overview

Employers incentivize long-term employment by giving them a strategic way to save for their retirement. 401(k) plans are employer-sponsored, tax-advantaged retirement plans that employers can offer to their employees. 

Another popular incentive is an SEP IRA, or a Simplified Employee Pension Individual Retirement Account. If a company has fewer than 100 employees, the employer may offer a SIMPLE, or Savings Incentive Match Plan for Employees, IRA instead. 

However, you don’t have to rely on your employer to create a tax-advantaged retirement account. You can independently open a traditional or Roth IRA, or Individual Retirement Accounts. Traditional IRAs let you make pre-tax contributions. However, if you have access to a 401(k) at work and your income exceeds $74,000 ($123,000 for couples filing jointly), you lose the deduction benefits. 

Your contributions to a Roth IRA are limited by your income level. In 2022, if your income exceeds $129,000 ($204,000 for couples filing jointly), you can’t contribute the full $6,000 amount. In fact, you can’t contribute at all if your income exceeds $139,000 ($206,000 for couples filing jointly). However, an employer-sponsored Roth 401(k) has no contribution limits. 

What’s a 401(k)?

A 401(k) is an employer-sponsored retirement plan that offers tax advantages to its contributors. Similar plans include 403(b) and 457 plans. Many employees also offer matching contributions under the plan. In these circumstances, employers match your contributions — partially or in full — up to a certain percentage of your income. For example, an employer might match 50% of your contributions up to 6% of your income. If you make $50,000, your employer will contribute $3,000 to your 401(k) for free provided that you contribute $6,000.

You can invest the contributions into a portfolio of investment options based on the selections your employer plan makes available. These funds have different risk levels, much like mutual funds. The contributions grow tax-free, and you don’t pay taxes until you start making withdrawals after you reach 59 1/2 years old. However, some plans allow employers to take loans or make withdrawals loans.

The 401(k) contribution limits in 2022 are $20,500 for employees under 50 years old and $27,000 for employees who are at least 50 years old. 

What’s an IRA?

Anyone can open an IRA, or an Individual Retirement Account, if they are under 70 1/2 years old. There are four types of IRAs:

  • Traditional IRAs: You can make pre-tax contributions, much like for a 401(k). Traditional IRA contributions can also be tax-deductible for individuals without access to employer-sponsored plans.

  • Roth IRAs: You make post-tax contributions to a Roth IRA. So while you pay taxes upfront, you won’t pay taxes when you make withdrawals during retirement. Individuals with high incomes may be ineligible to contribute to a Roth IRA.

  • SIMPLE IRAs: These employer-sponsored IRAs allow both employee contributions and employer matches. Employers will explain their specific contribution matching plan in their plan documents.

  • SEP IRAs: Your employer funnels your contributions directly into your SEP and without making contributions themselves. However, these IRA options are typically used by self-employed individuals and small business owners. 

IRAs have lower contribution limits than 401(k)s. Traditional and Roth IRA contributions are capped at $6,000, and SIMPLE IRA contributions are capped at $13,500 in 2021 and 2022.

IRA vs. 401(k): The Better Choice

Not only are 401(k) contribution caps over three times higher than IRA contribution limits, but employer matches make 401(k) even more valuable. Employer matching contributions are one of the most useful elements of a 401(k). If your employer matches all contributions, you receive a 100% return on investment immediately. This immediate added value also accumulates more earnings over time.

Two other factors that differ between IRAs and 401(k)s are the costs and plan flexibility. Many 401(k)s have 0-2% annual administrative costs. IRAs may have little to no fees and offer far more investment options.

Steps to Take if Your Employer Offers a 401(k) Match

If your employer offers a matching contribution to your 401(k), it’s important to make that your top priority. Employer matches are essentially free money. Before planning your retirement strategy, review your 401(k) plan documents to see if your employer offers a match and what amount you need to contribute to maximize that contribution.

Next, max out your IRA. Most individuals will need to choose between a traditional or Roth IRA. The right choice will depend on your current income tax bracket and your expected lifestyle during retirement. You can only contribute a total of $6,000 between your traditional and Roth IRAs, but you can split that total amount between the two accounts.

Then, return to investing in your 401(k). While you won’t see the same immediate return in investment, 401(k)s are still robust tax-advantaged retirement accounts. The contributions and your earnings will grow tax-free until you make withdrawals. 

After that, consider investing in a taxable account. These savings can form your emergency stash or be an additional source of taxable income.

Finally, strategize your portfolio allocation. Each of the funds you invest in through the different tax-advantaged and taxable accounts will have a certain amount of risk. Regularly reconsider the amount of risk you are willing to accept as you get older.

Steps to Take If Your Employer Does Not Offer a 401(k) Match

Even if your employer doesn’t offer matching contributions, you can still make contributions to your 401(k) a priority. However, investing in your traditional or Roth IRA should come first. This account generally has lower fees and more flexibility. You can choose your IRA service provider, select your preferred type of investments, and have more control over the costs and risks. Contribute the maximum amount based on your income and employment situation. Depending on your income level, your contributions may not be deductible or even permissible.

Only after you max out your IRA should you invest in your 401(k). While an employer match is a good savings incentive, so is the tax-deferred nature of the retirement account. Contribute as much as possible up to the contribution cap for your 401(k) plan year.

Both 401(k)s and IRAs offer strong benefits for people who make contributions. It’s especially important to prioritize your 401(k) if your employer offers matching contributions. If you want to learn more about creating a 401(k) plan with strong employee incentives for your company, contact Human Interest today.

We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.

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