Invest Retirement

IRA vs. 401(k) – What’s the Difference?

Nancy Mann Jackson  |  March 25, 2020

What's the difference between a 401(k) and an IRA?

Planning for retirement doesn’t have to be overwhelming. We’ll walk you through the differences between 401(k)s and IRAs.

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

These days, few people have access to “defined benefit” plans like the pensions that may have guaranteed your grandparents a certain payout from retirement through the rest of their lives.

Instead, most retirement plans are of the “defined contribution” variety, meaning you (and maybe your employer) contribute a certain amount each month, quarter or year, with the payout you receive during retirement based on the market value of the account.

IRAs and 401(k)s are among the most common defined contribution plans, and both offer tax-advantaged retirement savings. However, there are a few key differences between these types of plans. The good news is that you don’t have to choose one over the other. For the health of your retirement you can — and should, if possible — contribute to both a 401(k) and an IRA.

What’s a 401(k)?

A 401(k), as well as a 403(b) and 457, is a qualified employer-sponsored retirement plan. If your employer does not offer a 401(k) or other sponsored plan, you should probably just begin saving in a Roth IRA or traditional IRA. But if you have access to an employer plan — especially if the employer offers matching contributions — that’s the best place to start.

Many employers offer a matching contribution up to a certain percentage of your salary. For instance, if your employer will match your 401(k) contributions up to 6% of your salary, you should always contribute at least 6%. If not, you’re turning down free money.

The money you contribute to your 401(k) account is pretax money, meaning you will not be taxed on that money during the year you earned it. You will pay taxes on it when you withdraw it during retirement. During 2020, employees are allowed to contribute up to $19,500 of pretax income to a 401(k), and those over age 50 can contribute an additional catch-up contribution of $6,500.

What’s an IRA?

While the opportunity to contribute to a 401(k) is for the most part limited to people employed by companies that offer such plans, anyone can contribute to a traditional IRA (individual retirement account). (The one exception in 2019 is that those over age 70 1/2 aren’t allowed to contribute in a traditional IRA. The age restriction disappears in 2020.)

Like a 401(k), a traditional IRA offers tax-deferred growth on your investments, meaning the assets in the IRA will not be taxed until they are withdrawn. A traditional IRA may also offer tax-deductible contributions for people who don’t participate in an employer-sponsored plan.

A Roth IRA offers opposite tax advantages from a traditional IRA: You pay tax on income before you make contributions to the Roth IRA, but you’ll pay no tax on withdrawals of either your earnings or contributions when you make withdrawals in retirement. However, not everyone qualifies for a Roth IRA. To qualify in 2020, you’ll have to have an adjusted gross income that is less than $124,000, or $196,000 for married couples filing jointly.

The limit for annual contributions to an IRA is $6,000 for 2020, and $7,000 for people over 50. That limit is the same for both traditional and Roth IRAs. You have until the day your taxes are due (July 15 for the 2019 tax year) to set up and fund your Roth and/or traditional IRA for the previous year.

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