What is the Difference Between a 401k and an IRA?

A 401(k) is a qualified retirement plan that is sponsored by an employer. It allows employees to deduct a portion of their salary and put it into an account that is invested for their retirement. An IRA can be opened by an individual (hence the name Individual Retirement Arrangement) and is another vehicle that can help someone save for their retirement goals. You can participate in an employer-sponsored 401(k) and contribute to an IRA; you do not have to choose one or the other.

Both 401(k)s and IRAs are Tax-Advantageous Accounts

Before highlighting a few differences, let’s chat about the why. Why utilize either of these types of accounts? The short answer is that they are tax-advantageous vehicles that can help you get to your retirement goals. These types of retirement accounts can be tax-deferred or have tax-free growth characteristics. Most Americans enjoy the idea of delaying a tax bill from Uncle Sam and allowing their assets to compound. This is a powerful way to accumulate wealth long-term. 

401(k)s May Offer an Employer Match

Participating in your employer’s 401(k) plan can be advantageous because they might match a portion of your contributions. This is about as close an opportunity for “free money” as you will ever find. A 401(k) makes it easy for you to put money away from each paycheck toward your retirement. Once you are enrolled, the plan automatically takes a portion of your wages and puts it into your account. There are also ways to automatically contribute towards an IRA.

IRAs Need More Initiative from the Investor

Opening an IRA takes some initiative by the individual. This can be done through many channels but we have chosen to use TD Ameritrade/Schwab as the custodian for our clients’ IRA accounts. There are many flavors of IRAs; I’ll stick to the basics of a Traditional IRA and a Roth IRA in this blog post. In short, a Traditional IRA is considered a “tax-deferred” vehicle, and a Roth IRA is considered a “tax-free” vehicle. Keep in mind that very few things are truly tax-free and that the money you contribute to a Roth IRA has already been taxed. However, the “tax-free” piece of it refers to the capital appreciation, dividends, and earnings that can be tax-free if you follow the IRS rules. You can think of the tax treatment similarly when it comes to the difference between a Traditional 401(k) and a Roth 401(k).     

IRAs are typically funded from your bank account or from a rollover from your former employer’s 401(k) plan. You (or your spouse) must have earned income to contribute to an IRA. Note that Traditional IRA contributions can be tax deductible, if you are eligible (it depends on if you’re covered by a retirement plan at work, tax filing status, and income). The tax code allows you to contribute more money in a given year to a 401(k) than an IRA (for 2023 you can contribute $22,500 to your 401(k) and $6,500 to your IRA unless you are over the age of 50 you can contribute $30,000 to the 401(k) and $7,500 to your IRA). It is worth noting that for 401(k) plans with profit-sharing, the maximum annual additions (which includes employer profit-sharing contributions to a participant’s account) in 2023 is $66,000 ($73,500 including catch-up contributions). A rollover contribution to a Traditional IRA or Roth IRA is not subject to the annual contribution limit (or vice versa: A rollover from an IRA to a 401(k) is not subject to the annual contribution limit). 

Investment Option Differences Between 401(k)s and IRAs

A couple of other differences between a 401(k) and an IRA are the investment options and the ability to take a loan from the account. IRAs will have greater investment options whereas with a 401(k) you are often stuck with the investment lineup that is provided by your advisor on your employer’s plan. Your investment options might be somewhere around 20 mutual funds versus an IRA that has access to thousands of investment options. Some 401(k) plans will offer the ability to take a loan from the account and pay it back, with interest. IRAs do not allow this.

For the sake of keeping this a blog post vs. an all-out white paper, I decided to pick a few of the common topics that come up frequently in my conversations. There are other differences that might be worth considering when determining your strategy of how to divvy up your contributions to your 401(k) or your IRA (or a hybrid of utilizing both). Know that you are not alone in asking questions about the differences between these two common forms of retirement vehicles!

Mitch DeWitt is one of the co-founders and managing partners of Walkner Condon Financial Advisors. He is a fee-only, fiduciary financial advisor who works with clients locally in Madison and around the country.