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IRA vs. 401(k): Maximizing Your Retirement Savings

When planning for retirement, understanding the different types of tax-friendly retirement accounts is crucial. Two of the most popular options are IRAs (Individual Retirement Accounts) and 401(k)s. While a 401(k) is an employer-sponsored plan, IRAs are available through investment brokerages, banks, credit unions, and mutual fund providers. This means you can open an IRA on your own and fund it as you like, up to federal contribution limits.

Combining an IRA with a 401(k) can help strengthen your nest egg and secure valuable tax breaks. Leveraging both allows you to take advantage of their unique benefits. In this article, we will explore the differences between IRAs and 401(k)s, their pros and cons, and how you can benefit from having both.

IRA vs. 401(k)

These retirement accounts work a little differently, but they both allow you to set money aside for the future.

401(k)

A 401(k) is a tax-deferred retirement account provided through an employer. Employees can opt in, and contributions are typically made through automatic payroll deductions. Employers might also match some or all of what you contribute. The money you kick in is tax-deductible, reducing your taxable income today. However, you will pay taxes on distributions you take in retirement.

IRA

There are several types of IRAs available, with Traditional and Roth IRAs being the most common.

• Traditional IRA: Contributions may be tax-deductible, and your money will grow tax-deferred. Like a 401(k), you won’t pay taxes until you withdraw funds.
• Roth IRA: This type of IRA is funded with after-tax dollars, so you can withdraw your contributions at any time, tax-free. However, you may be taxed if you tap Roth IRA investment earnings before age 59½.

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

The short answer is yes—and here are a few reasons to consider it:

• Different Contribution Limits: In 2023, you can contribute up to $22,500 to a 401(k) and $6,500 across all your IRAs. Folks who are 50 and older can make additional catch-up contributions of up to $1,000 for the most popular types of IRA. If you max out your 401(k), you could continue saving in an IRA.
• Taxation of Withdrawals: 401(k) withdrawals count as taxable income, so you won’t keep all of your savings. The size of your distributions could also push you into a higher tax bracket. Having a Roth IRA in the mix can provide a pool of tax-free money in retirement, helping to offset your tax burden when you’re no longer working.
• Avoid Early Withdrawal Penalties: Withdrawing money from a 401(k) or traditional IRA before age 59½ will usually trigger a 10% penalty—not so with a Roth IRA. You can make an early withdrawal of your contributions to a Roth IRA if you retire early or encounter a financial emergency. This can provide some much-needed liquidity.
• Avoid Required Minimum Distributions: In 2023, you must begin taking distributions from tax-deferred retirement accounts at age 73. The age will bump up to 75 in 2033. Required distribution rules apply to 401(k)s, traditional IRAs, and inherited Roth IRAs. Regular Roth IRAs are exempt.

Pros and Cons of 401(k)s

Pros

• Higher contribution limits allow you to save more.
• Tax-deductible contributions reduce your taxable income during your working years.
• Tax-deferred growth means you won’t pay taxes until you withdraw funds.
• Potential employer match is essentially free money for retirement.

Cons

• Taxes can eat into your retirement income.
• Early withdrawal penalties apply if you take money out before age 59½.
• Required minimum distributions must begin at age 73, or you may face an IRS penalty.

Pros and Cons of IRAs

Pros

• Another way to save for retirement, helping to top off your nest egg.
• Tax benefits: Traditional and Roth IRAs provide unique tax advantages.
• Early withdrawal penalties and required distribution rules may not apply to Roth IRAs.

Cons

• Lower contribution limits compared to 401(k)s.
• Contributions may not be tax-deductible if you or your spouse have a 401(k).
• Early withdrawal penalties and required minimum distributions apply to traditional IRAs.

Is It Better to Have an IRA or 401(k)?

Neither an IRA nor a 401(k) is universally better or worse than the other. Both provide tax-efficient ways to save for retirement, each with its own perks and drawbacks. What’s right for you will depend on your unique financial situation. If you’re torn between a 401(k) or IRA, you might consider having both. The following questions can help bring things into focus:

• Does your employer offer a 401(k)? If so, you might consider opting in. Talk to your benefits team to get more information about signing up.
• Is there an employer match? What’s the minimum amount you’d have to contribute to get it? Your employer may match anywhere from 3% to 5% of your pay. It’s wise to kick in at least enough to secure a match.
• Do you have extra funds to contribute to an IRA? If you’re chugging along with 401(k) contributions and have room in your budget for more, you might put some cash into an IRA. The sooner you begin, the more time your money will have to benefit from compound interest. A Roth IRA might be a nice complement to your 401(k).

The Bottom Line

If you’ve got extra money to put toward retirement each month, an IRA could be a great way to build your savings on top of a 401(k). Both accounts have attractive tax perks. Just be sure you’re contributing enough to your 401(k) to get an employer match.

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