What’s the Difference Between a 401(k) and IRA?

When it comes to retirement planning, you’ll hear the terms 401(k) and IRA grouped together so often that you might start to believe that they’re the same thing. While it’s true that both types of accounts can be a great way to help you save for the future and avoid paying thousands of dollars in taxes, they are actually very different from one another. 

In this post, we’ll cover the major differences between a 401(k) and IRA.

How is an IRA Different from a 401(k)?

In the world of retirement planning, there are dozens of different tools that can be used to build your nest egg. A nest egg is simply a term used to describe the collective of your savings and investment accounts that you’ll eventually use to cover your living expenses once you’re no longer working.

Among the various options you could use, two of the most popular choices are the 401(k) and IRA. Here’s how each one works.

What is a 401(k)?

A 401(k) is an employer-sponsored retirement plan. In other words, you can only have one if you work for an employer that offers it.

A traditional 401(k) plan is what’s called tax-deferred. This means that any money you contribute to one doesn’t count towards your taxable income, and you won’t pay taxes on them this year. However, in the future when you eventually take that money back out for retirement (plus any earnings it’s made along the way), you will then have to pay taxes on it. 

Some employers offer a “Roth” style 401(k) option. Roth-style plans work the opposite of traditional-style plans – your contributions are taxed now but not in the future when you retire. Some people prefer this option because it gives you a lucrative opportunity to have tax-free income when you retire.

At its core, a 401(k) is just an investment account. You’ll contribute money to it and invest in various mutual funds made up of stocks, bonds, and other assets. The goal is to grow this account by letting the investments compound over time. The investment funds in a 401(k) are pre-selected by your employer, so you can only pick from the menu of options they’ve chosen.

The IRS lets you contribute up to $22,500 per year to a 401(k) (as of 2023) plus an additional $7,500 if you’re age 50 and older. Additionally, employers will often encourage their employees to participate in these plans by offering matching contributions. These can sometimes be dollar for dollar (up to a certain amount set by the employer).

What is an IRA?

By contrast, an IRA (individual retirement account) is a retirement plan that you set up for yourself. It’s completely separate from your employer and you can choose to open one with any financial institution you wish.

Just like 401(k) plans, IRAs can be either traditional or Roth-style – meaning you’ll get the same tax-advantaged benefits. However, the IRS does have some income limits on who is allowed to contribute to each specific type of account. You can find the latest information by visiting the IRS’s website here.

Similar to a 401(k) plan, the idea with an IRA is that you’ll invest your contributions for future growth. However, one major advantage is that you have complete control over the assets you choose. This means you can put your money into any fund, stock, bond, etc. that the financial institution offers.

One of the drawbacks of IRAs is that they do have significantly lower annual contribution limits. As of 2023, they are only $6,500 plus an additional $1,000 if you’re age 50 and older.

Can I Have Both a 401(k) and an IRA?

For most working Americans, the answer will be yes. This of course will depend on your individual financial situation as well as some other important details such as your tax filing status, income level, etc.

Generally speaking, most people would benefit from the combined power of having both a 401(k) and an IRA. In fact, couples who each have a 401(k) and IRA could potentially avoid paying tens of thousands of dollars in taxes now as well as a whole lot more in the future.

How to Use a 401(k) and IRA Together

If you’re relatively new to retirement planning, then it can be a little confusing knowing whether to start off with a 401(k), IRA, or to try to balance having both. For those people in this situation, here are some general guidelines to follow:

1) Start by contributing to your traditional 401(k) plan if it offers employer matching. 

Employer matching is basically your work giving you free money, so you won’t want to leave this opportunity on the table. It will be an easy way to add thousands of dollars to your nest egg every year – just for being a good saver.

2) Next, max out your Roth IRA

Almost every employer will have a limit on the amount of matching contributions that they’ll give you. Once that threshold has been reached, it may be a good idea to turn your attention over to a Roth IRA.  

Having both a traditional 401(k) and Roth IRA will give you the best of both worlds when it comes to tax savings. The traditional 401(k) will give you a tax break now, and the Roth will help ensure that at least some of your nest egg will be tax-free when you retire. 

This will also set you up for future optimizations. As your retirement plan matures, you can work with a financial professional to move portions of the traditional account over to the Roth when it’s most tax-efficient.

3) Go back to your 401(k) and contribute up to the max

With any remaining money you have left, circle back to your 401(k) plan and resume your contributions. Take them up to the IRS maximum if possible.

Even though you won’t be getting any more employer-matching contributions, you’ll still be decreasing your taxable income with each dollar you save. This is going to be a great way to save on taxes as well as accelerate your nest egg’s growth.

In summary, both a 401(k) and IRA are extremely useful tools to save and grow your nest egg so that you’ll have a very comfortable retirement. However, they only work if you regularly make contributions to them. Therefore, you’ll want to take action and find as many ways as possible to cut costs so that you’ll have more money available to save. 

This can be done by taking a closer look at your spending habits by using a helpful budgeting app such as Buxfer. Try monitoring your purchases for the next three months and get an understanding of where all of your money is going. 

By getting into this habit, you’ll start to recognize which transactions are important and which ones aren’t, and this will give you a good starting point for making changes. Remember: Every dollar more that you save has the potential to grow to be several more in the future. Therefore, it’s certainly worth the effort to increase your contributions as much as possible. 

Featured image credit: Pexels

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