If you’re contributing to a retirement account in the United States, you’ve probably debated IRA vs. 401(k).
The good news is that money expert Clark Howard thinks IRAs and 401(k)s can both help you secure your financial future.
In this article, I’ll highlight the basic differences between an IRA and a 401(k). I’ll also give you a roadmap for the order in which you should contribute to an IRA vs. a 401(k).
Table of Contents
- IRA vs. 401(k): Which Is Better?
- IRA vs. 401(k): Answering the Basics
- Benefits of an IRA vs. a 401(k)
- Benefits of a 401(k) vs. an IRA
- How Do I Prioritize IRA vs. 401(k) Contributions?
- Traditional vs. Roth: What’s the Difference?
IRA vs. 401(k): Which Is Better?
You don’t have to choose one retirement savings option over the other. But where should you put your first dollar? And how do you decide whether to contribute to both?
Let’s start by defining each option.
IRA stands for Individual Retirement Account. You can open an IRA on your own at a brokerage, bank or insurance company. Clark recommends Fidelity, Schwab or Vanguard. The maximum amount of money you contribute to an IRA each year is much lower than a 401(k). But you’ll have a lot more investment options. You may also pay less in fees and expense ratios.
A typical 401(k) is an employer-sponsored retirement plan. You fund your account by contributing money straight from your paycheck. Many companies offer a 401(k) match, which means that if you’re contributing, they’ll put money into your retirement account as well.
You’ll probably get a more limited selection of investment options than with an IRA. But the maximum amount of money you can contribute to a 401(k) each year is much higher than an IRA.
Keep reading for a deeper dive into both options. But if you’re choosing one to contribute to first, Clark almost always prefers a 401(k) to an IRA.
“If you’re with an employer that has a really low-cost 401(k) plan, keep it simple,” Clark says. “Because then the money automatically comes out of your paycheck. You don’t have to have the best of intentions to put the money in. Automatic is great.”
IRA vs. 401(k): Answering the Basics
Let’s answer some basic questions about IRAs vs. 401(k)s.
Who can open an account?
- IRA: anyone with earned income, though income limits exclude high earners from contributing to a Roth IRA
- 401(k): employees at companies that offer retirement plans
How much money can you contribute?
- IRA: $6,500 if you’re younger than 50; $7,500 if you’re 50 or older. A high modified adjusted gross income (MAGI) can phase out or exclude you from contributing.
- 401(k): $22,500 if you’re younger than 50; $30,000 if you’re 50 or older. Including employer contributions, the limit is $66,000 if you’re younger than 50 and $73,500 if you’re 50+.
What are your investment options?
- IRA: almost anything if you open your account with a brokerage or bank
- 401(k): limited, pre-selected options; usually all mutual funds (including target date funds)
How do you get started?
- IRA: Open an account on your own through almost any brokerage, investment company, bank or insurance firm. Clark recommends one of the Big Three investment companies.
- 401(k): Your employer may auto-enroll you. If not, you can self-enroll, which involves paperwork with your company’s benefits administration or Human Resources representative. You’ll contribute via automatic payroll deductions.
What about taxes?
- IRA: Taxes vary depending on whether you choose a traditional or Roth 401(k).
- 401(k): Taxes vary depending on whether you choose a traditional or Roth IRA.
Who’s eligible to contribute?
- IRA: You or your spouse must be earning income. There are income limits that could prevent you from contributing (Roth IRA) or reducing your taxable income (traditional IRA) if you make too much money. Those limits are different for traditional and Roth IRAs.
- 401(k): Some employers set length-of-service requirements before you can contribute. Others hold onto the company match until you’re “vested” by working there for a certain amount of time. But often you can contribute soon after you start work.
Benefits of an IRA vs. a 401(k)
Here are some of the advantages of an IRA, especially compared to a 401(k):
- More investment options. If you open your IRA with a major brokerage, you can invest in almost anything. Investment options through 401(k) plans are limited.
- Potential cost savings. Unlike 401(k) plans, many IRA custodians don’t charge annual management fees. Good brokerages may offer funds with lower expense ratios — plus, stock trading often is commission-free.
- No hassle when you change jobs. You can’t contribute to a 401(k) plan once you leave a company. It can also be stressful rescuing “orphaned” 401(k) accounts later if you don’t roll over your account right away. Those hassles don’t exist with IRAs.
- Available to anyone with eligible earned income. You can get a 401(k) only if you’re an employee at a company that offers you a plan. If you earn income and you are within the maximum income limits to contribute, you can put money into an IRA.
- Can open account at any time. Some companies have enrollment periods for 401(k) plans or require you to reach certain level-of-service requirements. You can open your own IRA at any time.
- Option to invest via a robo-advisor. If picking your investments is overwhelming or if you’re just worried about making the right choices, an IRA allows you to invest through a robo-advisor.
- No RMDs (Roth only). If you have a Roth IRA account that’s at least five years old, you don’t have to take Required Minimum Distributions (RMDs) once you reach 73 years old.
- Notable early withdrawal tax exceptions. If you withdraw from a retirement account before you turn 59½, you’ll owe a 10% penalty to the IRS. However, there are exceptions. For IRAs, that includes buying your first home, paying for college education and health insurance if you’re unemployed.
Benefits of a 401(k) vs. an IRA
Here are some of the advantages of a 401(k), especially compared to an IRA:
- Possibility of a company match. Some companies offer some sort of 401(k) match. If you’re contributing to your retirement plan, they’ll throw in money as well. In other words, with a 401(k) plan, you can basically get free money. That’s not possible with an IRA.
- Much higher contribution limits. If you’re younger than 50, you can contribute 3.5 times more money per year to a 401(k) than an IRA. If you’re 50+, that figure grows to four times more money.
- No income limits. If you earn a lot of income, it could limit or even prevent you from contributing to an IRA. No matter how much money you make, the IRS won’t restrict you from contributing to a 401(k).
- Stronger legal protection. Federal law usually protects 401(k) accounts from bankruptcies and lawsuits.
- Early withdrawal possible if you leave your job. You can withdraw from your 401(k) penalty-free if you leave your job between 55 and 59½ and meet certain conditions. There are other early withdrawal exceptions as well.
- Possible to delay RMDs if you’re still working. The IRS requires you to start taking withdrawals from your account when you’re 73 years old. However, if you’re still working for the company that holds your 401(k) plan, you can delay your RMDs.
- Good 401(k) plans can at least equal the best IRA options. The larger your employer, the more likely it is that they’ll offer a low-cost 401(k) plan. It’s difficult for a 401(k) to be less expensive than the best IRA options, but it can get close.
- Usually possible to take out a loan against your account. With some rare exceptions, you can’t take out a loan against your IRA account. But you can against your 401(k).
How Do I Prioritize IRA vs. 401(k) Contributions?
Let’s play a hypothetical game that, if we’re honest, we’ve all imagined at some point in our lives.
Pretend you just got an unexpected windfall. Perhaps you won the lottery, sold your business or got a large inheritance from a long-lost relative.
After earmarking 10% for fun (Clark’s suggestion), you’ve decided to invest the rest toward your retirement. You envision yourself traveling the world and enjoying your family well into your golden years.
It’s possible to contribute to an IRA and a 401(k). So, now that you have a big pot full o’ money, in what order should you invest your newfound cash?
1. Max Out Your 401(k) Match
Contribute enough to get the maximum 401(k) company match before you do anything else. There’s nothing like free, tax-advantaged money.
The costs of your 401(k) plan could be higher than the costs you’d incur through an IRA. But, for example, a 0.50% annual difference in administration fees and expense ratios pales in comparison to a 50% company match.
2. Evaluate Your 401(k) Plan and Aim for Your Contribution Limit
The general consensus is to contribute to your 401(k) up to the company match and then start contributing to a Roth IRA.
However, Clark says that it’s totally fine — perhaps even preferable — to max out your 401(k) contributions before turning toward an IRA. That’s especially true if you work for a large company with a low-cost plan and the option to contribute to a Roth 401(k).
Clark says that if your all-in expenses for your 401(k) – the expense ratios of your investments plus administrative costs — are lower than 0.5%, contribute up to the IRS maximum first. Then move to a Roth IRA.
“If you’re with a smaller employer, an employer with less than 500 employees, usually it’s going to be cheaper to pick up the employer match and then do your own Roth IRA,” Clark says.
If for whatever reason your company doesn’t offer a 401(k) match, you can consider opening a Roth IRA first. Just make sure you’re going to contribute every time you get paid.
Clark is a huge fan of 401(k) contributions because the money comes out of your paycheck before hitting your bank, taking away any temptation to spend the money.
3. Turn Toward an IRA
Remember, in our hypothetical, you came upon a large pile of cash. So once you’ve maxed out your 401(k) contributions, you can open an IRA and contribute there as well.
It’s totally legal and normal to contribute to a 401(k) and an IRA in the same year. However, there are some nuances involved.
Clark recommends Roth IRAs for most people. But if you make enough money, you won’t be eligible to contribute to a Roth. For 2023, that number is $153,000 in modified adjusted gross income (MAGI) — or $228,000 if you’re married and filing jointly.
As far as traditional IRAs go, if you’re covered by a retirement plan at work and make enough money, you won’t be able to take a deduction on your contributions. You can still contribute, but it won’t reduce your taxable income. That number is $83,000 in MAGI — or $136,000 if you’re married and filing jointly.
4. What If I Max Out My IRA and 401(k) Contributions?
Pat yourself on the back. You’re doing an excellent job of saving for your retirement, even if you inherited the money.
Clark thinks that outside of taking care of your basic necessities, saving for your retirement should be your top financial priority. If you want to do more, you have three primary options:
- Contribute to your HSA. If your company offers a Health Savings Account (HSA), your best option is to max out your HSA contributions next. In fact, if your all-in 401(k) costs are 0.5% or greater, Clark recommends doing this even before you reach your IRS-defined 401(k) contribution limits.
- Open a traditional brokerage account and invest that way. This type of account is called a “taxable” account because unlike a 401(k) or an IRA, it isn’t tax-advantaged. So be careful not to create additional tax burdens for yourself by selling frequently.
- Make non-deductible contributions to a traditional 401(k). If your company allows it, you can continue to contribute to your 401(k) past the normal limit ($22,500 if you’re younger than 50 and $30,000 if you’re 50+). However, these contributions won’t be tax-deductible and won’t reduce your taxable income. You’ll have to pay the IRS for these dollars, and there’s also a cap on the non-deductible contributions you can make. But the investments you make with that money inside your 401(k) can grow tax-free until you withdraw.
Traditional vs. Roth: What’s the Difference?
Whether you’re contributing to a 401(k) or an IRA, you may get to choose between Roth or traditional.
If you still aren’t confident about the difference, don’t fret.
When you contribute to a traditional 401(k) or IRA, you’re putting in pre-tax dollars. That means you haven’t paid any taxes to the IRS on those dollars. And you won’t pay any taxes until you withdraw the money in the future.
When you contribute to a Roth 401(k) or IRA, you’re putting in post-tax dollars. That means you’ve already paid taxes to the IRS on those dollars. And if you follow the rules, you won’t ever have to pay taxes on that money again.
Clark expects taxes to rise in the future. So unless you’re sure that your tax rate is higher now than it will be in the future, he thinks Roth (pay taxes now, avoid taxes later) is better than traditional (avoid taxes now, pay taxes later).
IRA and 401(k) accounts are both powerful retirement tools.
IRAs provide more flexibility and control. 401(k) accounts allow for company matches and higher contribution and income limits.
In a best-case scenario, you’re maxing out your contributions and taking advantage of both types of retirement accounts. But it’s hard to pass up the free money of a 401(k) if your employer offers a company match.