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

401(k) vs. IRA: An Overview

Saving for retirement is one of the most important financial goals that we need to achieve in our lifetime. The choice of which retirement savings account can help accomplish that goal. Whether it’s a 401(k) offered by an employer or an individual retirement account (IRA) that you established on your own, the benefits of these accounts can help ensure that you’ll have enough money to live on in your golden years.

When employers want to give their employees a tax-advantaged way to save for retirement, they may offer participation in a defined-contribution plan such as a 401(k). Employees would typically contribute a percentage of their salary to their 401(k), while the employer may offer matching contributions up to a specific limit. Employers might also offer a SEP (Simplified Employee Pension) IRA, or a SIMPLE (Savings Incentive Match Plan for Employees) IRA if the company has 100 or fewer employees.

Individuals can opt to save on their own and open an IRA. However, IRAs don’t provide matching contributions from an employer. Various types of IRAs have specific income and contribution limits, as well as their own tax advantages.

Both IRAs and 401(k)s grow tax-free, meaning there’s no tax on the interest and earnings over the years. However, distributions or withdrawals from these accounts are typically taxed at your then-income tax rate in retirement. However, there are IRAs that offer tax-free withdrawals in retirement. Most IRAs and 401(k)s do not allow withdrawals before the owner reaches the age of 59½; otherwise, there’s a tax penalty levied by the Internal Revenue Service (IRS). Again, depending on the specific retirement account and a person’s financial situation, there can be exceptions to the early withdrawal penalty.

401(k)s

A 401(k) is a tax-deferred retirement savings account offered by employers to their employees. Employees contribute money to their account via elective salary deferrals, meaning a percentage of their salary is withheld and contributed to the 401(k).

The money is deposited in various investments, typically a lineup of mutual funds, as selected by the sponsor. The fund choices are designed to meet a specific risk tolerance so that employees may only take on as aggressive or conservative a risk as they are comfortable with taking. Investment income accrues and compounds tax-free.

Many employers are also offering Roth 401(k)s. Unlike a traditional 401(k), contributions are funded with after-tax money, so they are not tax-deductible; however, qualified withdrawals are tax-free.

Employee Contributions

Contributions to 401(k) accounts are made pretax, meaning the total of the contributions would reduce your taxable income for that year by the contribution amount. For example, if an employee earned a $50,000 salary and contributed $10,000 to a 401(k), then the taxable income for the year would be $40,000—all else being equal.

As of 2021, participants can contribute up to $19,500 per year (increasing to $20,500 in 2022) to a traditional or Roth 401(k), with an additional $6,500 catch-up contribution allowed for people ages 50 and older.

Employer Matching Contributions

Employers typically match a percentage of their employees’ contributions up to a certain limit or percentage. An employer might match based on how much the employee contributes annually. For example, an employer could match 50% of an employee’s contribution up to 6% of their salary. If an employee contributes 6% of their salary, then the employer will contribute a 3% match.

If the employee doesn’t contribute the full 6%, they might not qualify for a match and receive either nothing or a reduced portion from the employer. To receive the employer match, the employee typically must contribute a minimum amount or percentage of their salary. It’s important to review the 401(k) retirement plan documents to determine if there’s an employer match, and if so, what the maximum match and the minimum employee contribution are to qualify for a matching contribution.

The IRS has established limits on total contributions—by both employee and employer—to a 401(k). For 2021, the total amount of annual contributions to an employee’s account can’t exceed $58,000 or $64,500, including catch-up contributions. Contribution limits increase in 2022 to $61,000 or $67,500 with catch-up contributions.

Distributions from 401(k)s

Withdrawals are taxed at the person’s income tax rate, and there’s no penalty for withdrawals as long as the distributions are made at age 59½ or older. An employee may be permitted to take loans or hardship withdrawals from a 401(k). Loan repayments are generally deducted from the employee’s paycheck.

Individual Retirement Accounts (IRAs)

There are several types of IRAs, which are tax-deferred retirement savings accounts established by an individual. IRAs can be held by banks, brokerages, and investment firms.

An IRA can be as straightforward as a savings account or certificate of deposit (CD) at a local bank. IRAs held by brokerage and investment firms offer IRA owners more investment options than 401(k)s, including stocks, bonds, CDs, and even real estate. Some assets, such as art, are not permitted within an IRA, according to IRS rules.

Traditional and Roth IRAs

Like 401(k)s, contributions to traditional IRAs are generally tax-deductible. Earnings and returns grow tax-free, and you pay tax on withdrawals in retirement. Contributions to a Roth IRA are made with after-tax dollars, meaning you don’t receive a tax deduction in the year of the contribution. However, qualified distributions from a Roth IRA are tax-free in retirement.

IRA Contribution Limits

Annual contribution limits for traditional and Roth IRAs are $6,000 as of 2021 and 2022, with an additional $1,000 catch-up contribution allowed for people ages 50 and older.

SEP and SIMPLE IRAs

SEP and SIMPLE IRAs are offered by employers to their employees and are similar to 401(k) accounts in many ways, but there are some differences—chief among them, their contribution limits.

SEP and SIMPLE IRAs were designed to make it easy for employers to set up a retirement plan for employees. They have fewer administrative burdens than 401(k) plans. For the self-employed, the term employer includes an owner/employee.

SEP IRAs

SEP IRAs have higher annual contribution limits than standard IRAs, and only your employer can contribute. Employer contributions can be as much as 25% of an employee’s gross annual salary as long as they don’t exceed a certain amount. In 2021, the contribution limit is $58,000, or $64,500 if the employee is age 50 or older. That amount rises to $61,000 or $67,500 for those 50 and older in 2022.

SIMPLE IRAs

SIMPLE IRA contributions work differently than SEP IRAs and 401(k)s. An employer can either match up to 3% of an employee’s annual contribution or set up a nonelective 2% contribution of each employee’s salary. The latter doesn’t require employee contributions.

The contribution limit for employees is $14,000 in 2021 and 2022. People 50 and over can make an additional catch-up contribution of up to $3,000.

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