What Is the Difference Between an IRA and 401(k)?

Summary: Understanding the key differences between an IRA and a 401(k) can help make an effective retirement plan for your financial goals and long-term savings.

Planning for retirement can feel overwhelming, especially when exploring options such as an IRA and a 401(k). Both are popular options, but understanding their key differences is essential for making the right decision. In this guide, we’ll break down the basics to help you determine how these plans might fit into your overall retirement strategy.

What is a 401(k)?

A 401(k) is an employer-sponsored retirement savings plan that allows employees to contribute a portion of their salary to a tax-advantaged account. Employers often match a percentage of these contributions, offering an added incentive for employees to save for retirement.

The money in a 401(k) grows tax-deferred, meaning you won’t pay taxes on the contribution and earnings until you withdraw the funds in retirement. With higher contribution limits than IRAs, a 401(k) can be beneficial for those looking to maximize their retirement savings. The investment options within a 401(k) are curated by the employer.

What is an IRA?

An Individual Retirement Account (IRA) is a personal way to save for retirement that offers a broader range of investment options compared to many employer-sponsored plans like 401(k)s. Unlike a 401(k), which is tied to your job, an IRA is set up individually, giving you access to a range of investment choices, such as stocks, bonds, mutual funds and ETFs. This flexibility allows you to tailor your retirement portfolio to your specific goals and risk tolerance.

There are two main types: Traditional and Roth IRAs.

• Traditional IRA: Contributions are typically pre-tax, which can lower your taxable income now, but withdrawals are taxed as ordinary income in retirement. It grows tax-deferred, but you’re required to start withdrawals at age 73.
• Roth IRA: Contributions are after-tax, so withdrawals in retirement are tax-free. The Roth IRA has no required minimum distributions (RMDs), allowing the money to grow tax-free over time without mandatory withdrawals.

Key Considerations:

• Complexity of Tax Rules: Taxes and withdrawal rules can be complex and vary based on income level. Consulting a tax advisor can help tailor an IRA to your specific needs.

For further reading, the IRS offers detailed guidance on IRAs and tax rules, or you might consult a tax advisor for advice specific to your financial situation.  Visit IRS.gov for more information.

Key differences between a 401(k) and an IRA

Let’s answer the question “What is the difference between IRA and 401k?” so you can focus on what really matters for your retirement planning.

Contribution limits

• 401(k): Higher contribution limits and individuals over 50 can add an additional set amount in catch up contributions. Visit IRS.gov for information on the contribution limits.
• IRA: Lower contribution limits with a set maximum per year. Individuals over 50 can contribute an additional set amount in catch-up contributions. Visit IRS.gov for information on the IRA contribution limits.

For the most up-to-date information, consult the IRS or an official financial planning resource, as these limits are subject to change.

Employer contributions

• 401(k): Employers often offer matching contributions, typically up to a certain percentage of your salary. This is essentially free money that helps boost your retirement savings. However, these employer contributions may be subject to a vesting schedule—a timeline that dictates when you gain full ownership of the matching funds. For example, if you leave the company before the contributions are fully vested, you might forfeit part or all of them. Check your specific plan for details on how and when contributions are fully vested.
• IRA: No employer contributions. You are solely responsible for your own contributions to the account.

Be sure to take full advantage of any employer match offered through a 401(k), as it’s a valuable way to maximize your retirement savings.

Investment options

• 401(k): Typically comes with a carefully selected range of investment options like mutual funds or index funds that an employer chooses to provide a balance of risk and growth opportunities. Employers often put a lot of effort into offering quality options, such as target-date funds, to help employees diversify with ease. Though the options may not be as extensive as an IRA, they’re chosen to make building a diversified portfolio straightforward.
• IRA: Offers a wider range of investment choices, including stocks, bonds, mutual funds, and even real estate in certain cases. This flexibility allows for greater customization based on your financial goals and risk tolerance.

Tax benefits

• 401(k): Contributions are typically made with pre-tax dollars, reducing your taxable income for the year. Taxes are deferred until you withdraw funds in retirement, where they are taxed as ordinary income. Depending on your 401(k) plan, you may be able to contribute post-tax dollars as a Roth 401(k).
• IRA:
  • Traditional IRA: Similar to a 401(k), contributions are made pre-tax, and taxes are deferred until retirement withdrawals.
  • Roth IRA: Contributions are made with after-tax dollars, but withdrawals in retirement are tax-free, given you meet the conditions.

For up-to-date information, it’s recommended to consult the IRS website or a tax professional.

Early withdrawal penalties

• 401(k): Early withdrawals (before age 59½) incur a 10% penalty plus applicable income taxes. Some plans offer exceptions, such as loans or hardship withdrawals, which may allow you to avoid penalties in certain situations.
• IRA: Both Traditional and Roth IRAs also impose a 10% penalty for early withdrawals. However, IRAs provide greater flexibility with exceptions, allowing penalty-free withdrawals for qualified expenses, such as a first-time home purchase (up to $10,000), qualified education costs, and certain medical expenses.

For more detailed information, always check the IRS guidelines or consult a financial advisor.

Variety in investment choices

• IRA: IRAs offer broad flexibility, allowing you to choose your provider and access a wide range of investment options, from stocks to mutual funds to real estate. This is ideal for those who want hands-on control, as it enables the freedom to manage, switch, and diversify investments independently.
• 401(k): A 401(k) plan typically offers a curated set of investment options chosen by the employer, which often includes mutual funds, target-date funds, and sometimes company stock. This structured selection aims to simplify investment choices. While tied to an employer, employees still retain the ability to select from the provided investments to align with their personal retirement goals.

Withdrawal options at retirement

• 401(k): You can take a lump sum, set up regular withdrawals, or roll the balance into an IRA. However, Required Minimum Distributions (RMDs) must begin at age 73, forcing you to withdraw a certain amount each year.
• IRA: Offers similar withdrawal options, but Roth IRAs stand out by not requiring RMDs during your lifetime, allowing funds to grow tax-free for as long as you want. This flexibility can be beneficial for maximizing your retirement savings.

Loan options

• 401(k): Some plans allow you to borrow against your balance, providing short-term access to funds without immediate penalties or taxes, as long as the loan is repaid on time. Failure to repay can result in taxes and penalties.
• IRA: Loans are not allowed. If you need access to funds before retirement, you’ll need to consider other options.

Here’s a table summarizing the key differences between a 401(k) and an IRA:

Feature	401(k)	IRA
Contribution Limits	Higher	Lower
Employer Contributions	Often includes matching contributions (free money for retirement)	No employer contributions; individual contributions only
Employer Contributions	Often includes matching contributions (free money for retirement)	No employer contributions; individual contributions only
Investment Options	Limited to employer-selected funds	Broader selection, including stocks, bonds, mutual funds, etc.
Tax Benefits	Pre-tax contributions, taxed upon withdrawal. Some plans allow for Roth (post-tax) contributions as well. Consult with your plan provider.	Two types: Traditional (pre-tax) and Roth (post-tax, tax-free withdrawals)
Early Withdrawal Penalties	10% penalty, some plans allow loans or hardship withdrawals	10% penalty, with more exceptions (e.g., first-time home purchase)
Account Structure and Investment Options	Tied to employer; may have limited investment options	More investment options, easily switch providers
Withdrawal Options at Retirement	Lump sum, regular withdrawals, or roll over into an IRA; RMDs apply	More flexible; Roth IRAs have no RMDs during the owner’s lifetime
Loan Options	Some plans allow loans against the balance	No loan options available

Which one is right for you?

It’s important to understand that the two accounts aren’t mutually exclusive. You can contribute to both. Here are some considerations to help guide you when making plans:

• Employer match: If your employer offers a 401(k) match, it’s wise to contribute enough to maximize that benefit—it’s free money that boosts your retirement savings.
• Investment options: IRAs typically provide broader investment choices like stocks, bonds, and mutual funds, while 401(k)s are more limited but still offer solid options.
• Contribution limits: If you’re 40+ and aiming to save aggressively, 401(k)s offer higher limits. IRAs have lower limits but can complement your overall savings plan.
• Taxes: If you want to reduce your taxable income this year, a Traditional 401(k) or IRA could help, as contributions are typically tax-deductible. Alternatively, if you’d prefer tax-free income in retirement, a Roth IRA offers that benefit, since contributions are made with after-tax dollars.
• Access to funds: Need flexibility? 401(k) loans may offer relief, while IRAs have specific penalty-free withdrawal options (e.g., for first-time home buyers or education).

You can work with an advisor to build a personalized retirement savings plan (maybe using both the 401k and IRA) based on your specific goals, desired retirement lifestyle and retirement income tax optimization.

Start planning for retirement today

Enrolling in a 401(k) or an IRA can be a great way to secure your financial future. Both retirement accounts offer unique benefits tailored to different needs and circumstances.

Whether you prioritize employer contributions, investment flexibility, or tax strategies, understanding the key differences can empower you to make informed decisions. Remember, the earlier you start saving, the better prepared you’ll be for retirement.

At Mutual of Omaha, we’re committed to providing resources and guidance to help you navigate your retirement journey and make the best choices for your future.

Frequently Asked Questions (FAQs)

Q1: What is the difference between an IRA and a 401(k)?

The primary difference is that a 401(k) is an employer-sponsored retirement plan, while an IRA (Individual Retirement Account) is established by individuals.

Q2: What is an IRA account and how does it work?

An IRA is a personal savings account that allows individuals to save for retirement with tax advantages. Contributions can grow tax-deferred until withdrawal during retirement. It’s crucial for anyone, especially those over 40 years old, to explore their options when considering an IRA.

Q3: Which retirement account is better for someone over 40?

For individuals around 40 years old, a 401(k) may be beneficial due to higher contribution limits and employer matches. On the other hand, an IRA provides more flexibility in terms of investment options, allowing you to select from a wider range of assets.

Q4: Can I have both an IRA and a 401(k)?

Yes, you can have both an IRA and a 401(k). Using both accounts can diversify your retirement savings strategy and provide you with more options when you retire.

Q5: Are there penalties for withdrawing funds from my IRA or 401(k) early?

Yes, both accounts impose penalties for early withdrawals before age 59½. Typically, there’s a 10% penalty for early withdrawals from both accounts, but IRAs have more exceptions for penalty-free withdrawals (like first-time home purchases or qualified education expenses).

Q6: What are the tax implications of a 401(k) versus an IRA?

Contributions to a 401(k) are typically made with pre-tax dollars, reducing your taxable income for the year. Traditional IRAs also allow pre-tax contributions, while Roth IRAs require you to pay taxes upfront. Withdrawals from a Roth IRA are tax-free in retirement, making it a potentially attractive option if you anticipate being in a higher tax bracket later. Note: some plans allow for post-tax (Roth) contributions. Check with your plan provider for more information on contributions and the impact to taxable income.

Q7: How do I decide which account to prioritize for retirement savings?

Consider your employer’s matching contributions with a 401(k) first, as this is essentially free money. If you prefer a wider range of investment options, or if you want to take control of your investments, an IRA may be the better choice. It can also be beneficial to utilize both accounts for a diversified savings strategy.

Q8: What happens to my 401(k) if I change jobs?

When you switch jobs, you typically have several options: leave the 401(k) with your former employer, roll it over into your new employer’s 401(k), or roll it into an IRA. Each option has different implications for access and management of your funds.

Disclosures:

All investing involves risk, including the possible loss of principal and there can be no assurance that any investment strategy will be successful.

Registered Representatives offer securities through Mutual of Omaha Investor Services, Inc., Member FINRA/SIPC. Investment Advisor Representatives offer advisory services through Mutual of Omaha Investor Services, Inc.

Mutual of Omaha and its representatives do not provide tax and/or legal advice, and the information provided herein is general in nature and should not be considered tax and/or legal advice.

Not all Mutual of Omaha agents are registered representatives or financial advisors.

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