When comparing IRAs and 401(k)s, one isn’t necessarily better than the other.
Both are investment accounts that can give you the tax benefits, flexibility, and freedom that you may be looking for in your financial planning.
“They have many similarities. They both serve as retirement savings vehicles that offer tax-deferred growth,” says Matt Rogers, a CFP and director of financial planning at eMoney Advisor, a financial planning firm.
The main difference is how you get one. A 401(k) is offered only through your employer, while almost anyone can open an IRA.
One thing to recognize with investing for retirement is that the earlier you start saving, the more time your money has to work for you. So don’t let the fear of choosing the wrong account get in the way of you getting started.
If you have can, max out both your 401(k) and IRA. Doing so will reap all the benefits available to you as an investor.
If you have the ability to (and enough funds), get both an IRA and a 401(k) — it’s very common — and max them both out to reap the benefits. But if you had to choose, let’s walk through what you’ll need to know to make an informed decision about when to use a 401(k) veresus an IRA.
What Is an IRA
IRAs are a great way to get started on your investing journey. An IRA is a retirement savings account that is not tied to employment. It stands for individual retirement account. You can open an IRA at most banks and brokerage accounts.
There are four main types of IRAs, and the two that you might come across most often are Roth and traditional. Depending on your investment goal, one might be better for you than the other. But they’re both great.
With a Roth IRA, you contribute income that you’ve already been taxed on. Whatever you contribute, you can take out whenever you wish with no penalties. At 59 ½, you can take out all your money (including the profits) and pay zero in taxes.
A traditional IRA works a bit differently. You put in pre-tax dollars, meaning anything you contribute is shielded from ordinary income taxes. Then, when you withdraw the money at age 59 ½, you pay taxes on it, plus the earnings.
Both IRA types have an annual contribution limit of $6,000. Experts generally recommend Roth IRAs for beginning investors, but you can’t go wrong with either.
Pros of IRAs:
Easy to get – IRAs are available to almost anyone, regardless of their employer. Find yourself a brokerage account that you love (we recommend Fidelity, Vanguard, or Charles Schwab) and open one up there.
“Choose a broker , open the account, contribute money from your checking or savings into this account, and then invest the money. And there you have it—you’ve started investing,” says finance mentor Ceci Marshall, who runs @financesreimagined on Instagram.
Investment variety – IRAs don’t have too many restrictions when it comes to the investments you can choose — you can invest in pretty much anything. Choose between index funds, ETFs, stocks, or bonds. The most recommended investments are index funds, which help spread out your investment throughout the entire stock market. For example, consider an index fund that follows the S&P 500, which are the 500 largest public companies in the U.S.
Cons of IRAs:
Lower contribution limits – IRAs have lower contribution limits when compared to 401(k) plans. For 2021, participants under 50 years can contribute up to $6,000. Participants 50 years and older can contribute up to $7,000. We should note that these limits change with SEP IRAs, which are a special kind of IRAs available to freelancers.
What Is a 401(k)
A 401(k) is a retirement savings account offered through your employer. If your job offers a 401(k) plan with a company match, make sure you are depositing enough to get that match. If not, you’re literally missing out on free money.
Pros of 401(k)s:
Employer match – Arguably, the best thing about a 401(k) is that many employers that offer these plans also offer employer matching programs up to a certain amount. This is essentially free money, and if you can afford it, you should contribute up to the point of your company’s match each year in order to take full advantage.
Higher contribution limit – 401(k) plans have much higher contribution limits compared to traditional and Roth IRAs. For 2021, contribution limits for 401(k) plans are $19,500 for participants under 50 years and $26,000 for participants 50 years or older.
Cons of 401(k)s:
Only offered through employment – 401(k) plans, especially those with employer matching programs, are great if you can get one. But not all employers offer them. If you’re not offered a 401(k), that’s OK. Open up a Roth or Traditional IRA and get started.
Investing options can be limited – While the federal rules governing 401(k) plans don’t restrict investments, many employers offering the plans do. So if you opt for the 401(k) plan your company offers, you may only have a couple options for the investments you can choose.
Which Is Better?
Personal finance is personal, so your individual situation and financial circumstance will dictate which choice will work best for you.. But don’t let fear of investing prevent you from getting started. Just pick an investment option and go with it.
If your employer is willing to match your contributions in a 401(k), and you only have the funds to fund one account, the difference between IRA and 401(k) is clear — the 401(k) will provide you with a greater investment at the same cost to you.
“If given the option to invest in either, a key benefit of a 401(k) is that most employers will offer an employer match on employee contributions. Employers offer this benefit to encourage participation in the retirement plan and attract employees,” says Rogers. “This ‘free money’ should be taken advantage of because it can result in larger account balances.”
But you don’t have to stop there. If you have the income where you can put $19,500 towards your 401(k) and $6,000 towards your IRA, then absolutely you should invest in both.
How to get started investing in either IRAs or 401(k)s?
If you want a 401(k) plan, check to see what your employer offers. You can only get a 401(k) plan through your job. The HR department is a good place to start looking for information about 401(k) plans at your work.
If you want an IRA, all you need to do is open an account with a broker. Figure out which IRA is best for you (a Roth is great for all investors, but you need to earn income in order to use it). Deposit your money and make sure it’s invested.
IRAs and 401(k)s are not mutually exclusive — you can get both.