IRA vs. 401(k): How to choose the right retirement option for you
- June 5, 2023
- 5 min read
Differences between IRAs and 401(k)s
Types of IRAs and 401(k)s
2023 contribution limits
It’s easy to see why saving for retirement is essential. But what’s not always so simple is understanding how best to use different savings options to your advantage. That’s where retirement-specific investment accounts like 401(k)s and individual retirement accounts (IRAs) come in.
Both IRAs and 401(k)s offer tax advantages to help incentivize saving for retirement. The main difference between IRAs and 401(k)s is that you open an IRA through a bank or broker, like Ally Bank or Ally Invest and you get a 401(k) plan through your employer.
|Employer match||Sometimes offered||Not available|
|2023 contribution limit||$22,500 ($30,000 age 50+)||$6,500 ($7,500 age 50+)|
|Investment choices||Limited by employer plan||Variety of choices|
|Eligibility||Not limited by income||Can be limited by income|
One of the best features of an IRA is its flexibility. You can use an IRA to supplement your 401(k) plan, or you can open one on its own. You can choose from three main types of IRAs, allowing you to tailor your savings strategy to your personal situation.
Traditional IRAs allow you to typically deduct your contributions (subject to income levels). This means you can put earnings toward investments that can grow tax deferred. Your money is then taxed when you take it out.
With a Roth IRA, you contribute after-tax dollars, so your distributions during retirement are tax-free. If you expect to be in a higher tax bracket when you withdraw your money versus when you are contributing, it could be beneficial to consider a Roth IRA.
A 401(k) is an employer-sponsored retirement plan, meaning they are offered through a workplace. Like an IRA, a 401(k) can be traditional or Roth.
With a traditional 401(k), your contributions are made pre-tax, which can reduce your taxable income. You pay taxes on the contributions and investment earnings when you make distributions, typically during retirement.
As you might predict, contributions to a Roth 401(k) come from your after-tax income. Not all employers offer this option, but you may find it worth exploring to see if your workplace does. Investment earnings and contributions are not taxed when you withdraw during retirement.
One of the biggest benefits of a 401(k) is that your contributions come directly out of your paycheck, based on a percentage of your choosing, up to a certain limit. Because your money is deposited automatically, you don’t have to worry about transferring money from your take-home pay.
A plus for 401(k) plans is your employer typically offers to match some of your contributions. For example, they may match your contributions dollar- or-dollar up to 3% of your salary. It’s basically like getting additional compensation from your employer. That extra contribution could go a long way for you.
As we mentioned in the chart above, both IRAs and 401(k)s have annual contribution limits that are set by the IRS. These limits are subject to change annually based on inflation and cost-of-living adjustments. The IRS also sets catch-up contribution limits, which allow individuals over 50 years old to contribute an additional amount to their retirement accounts.
In 2023, the contribution limit for an IRA is $6,500 (up from $6,000 in 2022), with a catch-up limit of $7,500 for those 50 and older. The contribution limit for a 401(k) is $22,500 (up from $20,500 in 2022). Those 50 and older can contribute up to $30,000 in 2023.
Yes, you can have both an IRA and a 401(k) and doing so may be a great retirement savings strategy. If you find yourself maxing out your 401(k) and you need an additional way to save, IRAs may help you stash away another $6,500 to $7,500 per year (depending on your age and income level).
In addition, opening an IRA may give you investment alternatives you likely don’t have in your workplace plan. First, you can choose between doing it yourself or using a robo-advisor . If you DIY, you have a variety of investment products to pick from, including mutual funds, exchange-traded funds ( ETFs ) and individual stocks and bonds.
You can also open IRA deposit products, like savings accounts and certificates of deposit (CDs), at a bank if you like the idea of a portion of your savings being FDIC-insured up to the maximum amount allowed by law, (so long as the bank you choose is insured).
Having an IRA and a 401(k) lets you diversify your tax advantages, meaning some retirement savings can be taxed up front and some may be taxed as ordinary income when you pull it out. You can employ a variety of strategies when it comes to taxes and retirement savings. Talking with a tax professional can help you decide what’s best for you.
Whether you concentrate on putting your retirement savings into a 401(k) or IRA first depends on whether or not your employer offers to match 401(k) contributions. For some, it might be a good idea to contribute enough to get the maximum match and then get started with IRA contributions.
If your employer doesn’t match contributions, you might choose to fund an IRA first (because you have more investment options), then put money toward a 401(k).
Investing for retirement is a great opportunity to set yourself up for your future. While there’s no right or wrong way, making the most of IRAs and 401(k)s may give your retirement savings an extra boost.