Updated: Apr 01, 2024

401k vs. IRA: Which Retirement Plan is Better?

There are two main types of retirement plans: employer sponsored 401K plans and IRA accounts. Learn which retirement plan better for you and how to choose it.
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401K vs IRA

Retirement was so much simpler for my folks. They did their time, and are now collecting pension and Social Security checks.

Today’s generation pretty much has none of these benefits, are probably more in debt and the concept of retirement isn’t even on the radar.

If you're one of the few that can still count on a pension, consider yourself lucky and secretly I am jealous. For the rest of us, the concept of set it and leave it wont work when it comes to planning for retirement.

These days hard-working Americans need to have the answers to questions like; when do I want to retire and/or how much do I need to survive after the paychecks go away.

In a recent study done by Prudential, some interesting insights were shared from a question asked to Millennials, Gen Xers, and Boomers about what stage they are at in their retirement savings plan. Here's some of their findings:

  • 58% of Gen Xers are saving regularly for retirement, while 56% of Boomers are saving regularly and only 48% of Millennials.
  • A surprising 28% of Boomers are not sure how much they are saving for retirement, while 23% and 21% of Gen Xers and Millennials, respectively, are unsure of how much they are saving for retirement.
  • On the other hand, a not surprising 31% of Millennials are not saving at all for retirement, whereas only 19% of Gen Xers are not saving and 16% of Boomers are not saving for retirement.

With more than 50% of those surveyed, that are before the age of retirement, believing that most of their post-retirement income comes from savings accounts, wouldn't you think that 100% of these generations would be saving more?

With all of that being said, the generational differences in these percentages indicates the concept of retirement becomes more of a focus in a persons 40's — in today’s market this may be a little to late.

There are really two main types of retirement plans: the first are employer sponsored 401K plans, which can come in the form of 403b and 457 plans. The second type is individual plans, or more commonly known as IRA accounts.

Choosing which one is right for you depends on your preferences and goals come retirement.

Both allow individuals to save money for retirement; they also have several key differences, which we've highlighted below.

Comparing your Options

As mentioned above, 401k plans are employer-sponsored and allow employees to set aside a portion of their paycheck pretax.

The contribution limit is currently $19,500, but if you are over the age of 50 you can add an additional $6,500, known as a catch-up contribution. Most of your contribution is placed into mutual funds.

For IRAs the contribution limit is significantly lower, with a max of $6,000 per year or $7,000 if you are over the age of 50.

Traditional IRA Vs. Roth IRA

Traditional IRA Roth IRA
Contributions may be tax-deductible. Contributions are not tax-deductible.
Pay taxes upon withdrawal. Earnings can be withdrawn tax-free and without penalties if the funds were in the Roth IRA for 5 years and you've reached age 59 1/2.
You must be under age 70 1/2 to contribute. You can contribute at any age.
Required minimum distributions (RMDs) are required starting at age 70 1/2. No RMDs required.

Withdrawals begin at age 59 ½ and are mandatory by 70 ½ of the last day of the calendar year. IRA account funds can be used to purchase various investments, such as stocks, bonds, CDs, ETFs.

Let’s dive a little deeper to understand which option is best for your situation.

401k's vs IRA's

The first clue to making a choice is to figure out the benefits your 401k offers vs. the benefits your IRA offers, benefits such as matching contributions.

Employer matching your contributions

Quite possibly the biggest perk of having an employer-sponsored 401k is the free money that comes along with it. That's right, free money.

The concept of "matching contributions" is basically when your employer matches the money you set aside, one-for-one, up to 6% of your salary. As an example, if you had an annual salary of $50,000, you could earn an additional $3,000 in free, employer-matched, money.

I should point out that most employers who choose to match do so at 50 cents for every dollar contributed.

Though 401k’s can sometimes come with expensive administrative and fund management fees, keeping an assumption of an annual rate of return of 7%, maxing out your 401k, match or no match it is still a great option.

If your employer does not offer a 401k plan or you think you won't be with the company for that long, the other option is a Traditional or Roth IRA. The main difference between the two is how you pay taxes on the amount you contribute.

For Traditional IRAs, the up to $6,000 that you can contribute each year qualifies for a full tax deduction; as opposed to Roth IRAs contributions, which are not tax-deductible.

Unlike Traditional IRAs, where you only pay on the amount once withdrawn, Roth IRAs grow federally tax-free.

Money you withdraw is not taxed if your Roth IRA is open at least five tax years and your past the age of 59 ½.

For the Self-Employed

As an entrepreneur or someone who earns additional income outside of their day-to-day job, maybe through freelance or consulting, retirement plans such as Solo-401k's and SEP-IRAs (Simplified Employee Pension) work almost the same with additional benefits.

For those who are entrepreneurs or run their own business that hasn't started a Solo-401k and don't plan to, you should definitely be considering an IRA as you can contribute 25% of your compensation up to $58,000 ($64,500 if 50 or older), which can be claimed as a 100% tax-deductible business expense.

Come to tax-season, this can be a huge benefit to keeping your investment locked towards your retirement plan, instead of handing it over to the government.

If freelancing or being self-employed is something you plan to continue, and you haven't waited till tax season to plan, it could be worth considering a Solo-401k.

Though it is more expensive to set up, a Solo-401k offers similar tax advantages as SEP-IRA, with the added benefit of higher contribution limits.

Where the SEP-IRA is capped at 25% of compensation, a Solo 401(k), which also carries a cap of $58,000 ($64,500 if age 50 or older), allows profit-sharing contributions of up to 25% plus tax-deductible salary deferrals to the plan of up to $19,500 ($26,000 if 50 or older).

So while the caps are the same, you can make very little self-employed income and basically defer it all, which you can’t do with the SEP-IRA.

As with employer-sponsored 401k plans, if your self-employed income is large enough that you max out the Solo-401k, you can always contribute to a SEP-IRA.

Which Retirement Account Should You Choose

Choosing between the two retirement accounts depends on your situation. Do you think you will need the money come retirement? If not, an IRA is a great option as it lets you pass money on to others such as your children.

If you plan on using the money for yourself, you should try to determine if your tax rate will be higher when you contribute to the fund or when plan to withdrawal from the fund.

If you think you will be in a lower tax bracket a 401k or Traditional IRA is a better choice as you pay taxes when the money is withdrawn.

If you’re in the other bracket and your taxes are only going up, a Roth IRA can be the better choice as you pay taxes as you contribute.

Another point to consider is if you will need the cash before the age of 59 1/2. As we highlighted in our article on what to do with your Old 401k Plans withdrawal can leave you with huge penalty fees of up to 10%.

In the end, it's time to recognize that we no longer live in a time of set and leave as the older generations once did.

If living a comfortable life come retirement is something we want we need to start saving now.

Max out your 401k plan, take advantage of  any matching your current employer offers, but don't stop there.

Open an IRA — it's not associated with any employer, you don’t have to worry about transferring the funds and it can also grow tax-free.