Today, investors commonly have access to two retirement savings accounts: an IRA or a 401(k). Choosing or utilizing both accounts is a strategic decision on your path to financial freedom. Knowing the differences of these accounts and how to leverage them best can help you maximize your savings and help you grow your nest egg over time.

Similarities Between an IRA and 401(k)

The Individual Retirement Account (IRA) and 401(k) were both created under the Employee Retirement Income Security Act of 1974 (ERISA). Their shared goals were to encourage investors to save for retirement by offering tax advantages. Some similarities between these two accounts include:

Tax advantages: Both IRAs and 401(k)s offer tax benefits, whether you opt for a Traditional or Roth account. In a Traditional IRA or 401(k), your investments grow tax-deferred, while in a Roth version, they grow tax-free. These two types of accounts are exempt from capital gains tax, a benefit most standard brokerage accounts don’t provide investors. Investors can also reduce their taxable income when contributing to a Traditional IRA or 401(k), which can benefit high-earners.

Account availability: IRA and 401(k) accounts are offered as Traditional and Roth options. The former means that contributions are made with pre-tax income, while the latter is made with post-tax contributions. The similar availability of these accounts makes it easy to leave a job and roll over your existing 401(k) to a similarly taxed IRA.

Withdrawal implications: IRA and 401(k) accounts have similar withdrawal rules. Investors must wait until 59 ½ to withdraw funds without penalty, true for both Roth and Traditional accounts. If you withdraw funds before 59 ½, a 10% additional penalty applies to distributions from Traditional accounts and earnings from Roth accounts. Keep in mind that investors can withdraw Roth contributions at any time tax and penalty-free since you already paid income taxes. There are several exceptions to the 10% penalty, which apply to both IRA and 401(k) accounts. Other withdrawal implications include the Roth five-year rule and Traditional IRA Required Minimum Distributions (RMDs).

Differences Between an IRA and 401(k)

While these accounts share several features, they also have notable differences in contribution limits, investment options, and accessibility.

Contribution limits: The contribution limits differ significantly between IRAs and 401(k)s. For 2024, IRA contributions are capped at $7,000 (or $8,000 if you’re over 50). Meanwhile, 401(k) contributions are much higher, with limits of $23,000 for those under 50 and $30,500 for those 50 and older. When factoring in employer contributions, 401(k) contributions can reach as high as $69,000 (or $76,500 for those 50 and older).

For self-employed individuals, SEP IRAs and SIMPLE IRAs offer higher limits. SEP IRAs allow contributions of up to $69,000 or 25% of salary, whichever is lower. SIMPLE IRAs permit contributions of up to $16,000 (or $19,500 if over 50).

Investment choices: 401(k) plans typically have fewer investment choices than IRAs. Within 401(k) accounts, investors can choose between various mutual funds, many of which track broad market indices. On the other hand, IRAs provide access to various investment options, including stocks, mutual funds, ETFs, and financial derivatives based on the investor’s sophistication.

Account access: Individual investors can open an IRA account by signing up for an account online. Only employers can open a 401(k) account for an employee as part of a workplace benefit. Since 401(k) accounts are a workplace benefit, many companies contribute to their employee’s accounts. IRAs don’t allow for employer contributions, meaning that the investor must make all IRA contributions directly.

Income limits: Although there is no defined income limit on being eligible to contribute to your 401(k), the IRS states that an employer’s matching contribution can only factor in up to $345,000 of an employee’s salary in 2024. This rule is enforced alongside the 401(k) account total contribution limit of the lesser of 100% of an employee’s salary or $69,000.

Traditional IRAs also have unique income-dependent eligibility rules. If you are covered by an employer’s retirement plan and contribute to your Traditional IRA, the following rules apply to you in 2024:

Single filers:

· Modified adjusted gross income (MAGI) of $77,000 or less: you can deduct the full $7,000 contribution maximum.

· Modified adjusted gross income (MAGI) between $77,000 and $87,000: your deduction is phased out until your income passes $87,000.

· Modified adjusted gross income (MAGI) over $87,000: you cannot deduct pre-tax contributions to your account.

Joint filers:

· Modified adjusted gross income (MAGI) of $230,000 or less: you can deduct the full $7,000 contribution maximum.

· Modified adjusted gross income (MAGI) between $230,000 and $240,000: your deduction is phased out until your income passes $240,000.

· Modified adjusted gross income (MAGI) over $240,000: you cannot deduct pre-tax contributions to your account.

Roth IRAs do have income limitations to be eligible to contribute.

Single filers:

· Modified adjusted gross income (MAGI) of $146,000 or less: you can contribute the full $7,000 maximum.

· Modified adjusted gross income (MAGI) between $146,000 and $161,000: your contribution is phased out until your income passes $161,000.

· Modified adjusted gross income (MAGI) over $161,000: you are not eligible to contribute to a Roth IRA.

Joint filers:

· Modified adjusted gross income (MAGI) of $230,000 or less: you can contribute the full $7,000 maximum.

· Modified adjusted gross income (MAGI) between $230,000 and $240,000: your contribution is phased out until your income passes $240,000.

· Modified adjusted gross income (MAGI) over $240,000: you are not eligible to contribute to a Roth IRA.

Liquidity needs: Some 401(k) plans can provide loans, whereas the capital is paid back into your 401(k) at a certain interest rate. IRAs do not offer loans; however, both types of accounts allow certain withdrawal exceptions to access funds without a 10% penalty.

Key Considerations for Contributing to IRAs and 401(k)

It’s possible to contribute to both an IRA and 401(k) to maximize your retirement savings.

Your contribution strategy may be based on whether your employer matches your 401(k) contributions.

If your employer matches your 401(k) contribution, it’s common for investors to first contribute up to their employer’s matching limit before maxing out their IRA. If any money is left over to invest, many investors return to their 401(k) until it’s maxed out.

However, if your employer does not match your 401(k) contribution, investors may max out their IRA before contributing to their 401(k).

The Bottom Line

The choices you make when investing in your IRA and 401(k) will impact how you save for retirement over your working years.

Understanding the differences, and how you may be able to benefit from both account types is a critical step in preparing for retirement.

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