401K vs. IRA | Key Differences Every Investor Needs To Know in 2023

In the face of increasing global economic uncertainty, many investors are finding themselves faces with an important decision regarding their 2023 investment options.

The consensus seems to be that moving away from paper assets, such as mutual funds, stocks, and bonds, and choosing an individual retirement account that offers tax advantages is the better choice.

However, the decisions do not end there, unfortunately. There is still the difference between a 401(k) and IRA plan that needs to be considered. Here the investment options offered by both an IRA vs. 401(k) have a lot of similarities but also some key differences that may affect the decision-making process.

In this article, we will look at some of the most important things you have to consider before deciding where to invest your retirement funds. In particular, we will focus on three types of IRAs, which are:

  • 401(k) plans

  • Roth IRA

  • Traditional IRA

Read on to find out which tax-advantaged retirement account is best for you in 2023!

Key Takeaways

401K vs. IRA
  • As long as you are eligible, you are allowed to make contributions to both a 401k or Roth IRA

  • Unlike paper assets, such as mutual funds, both 401(k)s and IRAs offer significant tax advantages

  • 401k vs traditional IRA and Roth IRA plans offer options for contributing on a Roth IRA basis using after-tax dollars or on a Traditional IRA basis using pre-tax income

  • There are important annual contribution limits to consider in either type of retirement savings account

  • A 401(k) account is usually opened and funded through employer contributions while you open an IRA individually

Difference Between an IRA vs. 401(k) - Traditional IRA vs Roth IRA vs 401k

Having to pay taxes on investments is one of the things that drives investors away from mutual funds and towards either an IRA or a 401(k). However, the differences between Roth IRA and 401k accounts start right at the beginning.

An IRA, or individual retirement account, is usually opened by the individuals themselves without the involvement of an employer.

This type of account can be either a Traditional IRA or Roth IRA depending on the tax deduction, annual contribution limit, and required minimum distributions.

However, it is important to note that certain types of IRAs can be opened by an employer, such as:

  • Simplified Incentive Match for Employees (SIMPLE) IRA

  • Simplified Employee Pension (SEP)

With a 401(k), these retirement accounts are almost exclusively opened by an employer on behalf of an employee. A 401(k) generally has the same tax advantages that you get in a Roth IRA or Traditional IRA.

Funding the 401(k) account usually relies on an employer match system, whereby employer contributions are made to match employee contributions. Matching contributions in this way allows the account to grow much faster.

The Employee Retirement Income Security Act (ERISA) is a Federal Law designed to set the minimum standards by which employers in the private sector are expected to operate.

One of the main concerns that investors have is regarding the tax advantages offered by either a 401(k) account or an IRA. These advantages do differ along with a wide range of other aspects which we will now discuss.

Type of Individual Retirement Account

401(k) accounts are usually the same from one account holder to the next. However, the same cannot be said for IRAs. With individual retirement accounts, there are two main options to choose from, which are either a Traditional or Roth IRA.

traditional ira

One of the defining characteristics of a Traditional IRA is that you are allowed to make tax-deductible contributions to the account. The specific tax deduction you are entitled to depend on the employer match you are receiving, your tax filing status, and your income limits.

In most cases, with a Traditional IRA, the tax benefits mean that you will only be taxed when you make withdrawals in retirement.

Roth ira

The first thing you should know about a Roth IRA is that it is funded with after-tax dollars. All withdrawals in retirement will be tax-free money provided that you have followed specific IRS rules and regulations, for example, no money can be deducted for tax purposes.

With both a Roth IRA and Traditional IRA, you will likely incur a 10% early withdrawal penalty for withdrawals made before reaching retirement age.

401(k) Tax Treatment

401K Individual Retirement Account

A 401(k) works by deferring a portion of your salary into your retirement account. This money can be in the form of employer contributions, employee contributions, or both in the case of an employer match. This is why a 401(k) can sometimes be referred to as an employer-sponsored retirement plan.

The money is usually invested further into bonds, stock funds, or mutual funds to allow it to grow over time.

A 401(k) retirement account is a type of tax-advantaged account. However, the tax benefits you will get depend on the specific type of 401(k) account you have.

Traditional 401(k)

A Traditional 401(k) account can be identified by the following features:

  • The account holders fund their 401(k) using pre-tax income, meaning the money is taken from the salary before income taxes have been removed which will lower the taxable income significantly when the account holder decides to make withdrawals in retirement

  • Your 401(k) account will grow tax-deferred without you having to pay taxes such as capital gains taxes

  • When you finally make withdrawals, your distributions in retirement will be taxed at the same rate that you pay income taxes

Roth 401(k)

The defining characteristics of an IRA Roth/IRA 401k account are:

  • All contributions are made using after-tax money, meaning you will only be able to make contributions from your taxable income without any upfront tax deduction

  • Your 401(k) account will grow tax-free over the years, also called tax-deferred investment growth

  • With a Roth 401(k), because you already contributed from taxable income, you do not have to pay taxes when you make distributions in retirement as long as you do so at the appropriate retirement age.

  • Any contributions you received through an employer-sponsored plan or matching contributions should be kept in a separate account as these will not be eligible for tax-free distributions in retirement

The growing popularity of Roth 401(k) retirement accounts has resulted in nearly 90% of all 401(k) being structured in this way according to the 64th Annual Survey of 401(k) and Profit Sharing Plans conducted by the Plan Sponsor Council of America.

Also Read:  401k to gold IRA rollover guide.

Contribution Limits

With both a 401(k) and an IRA, the annual contribution limit is another very important consideration to make when choosing a retirement plan because it directly impacts the growth of your retirement account and how much money you will be expected to set aside for retirement each year.

These contribution limits are set by the IRS which effectively puts a cap on how much an IRA or 401(k) account holder can contribute towards their retirement savings account without missing out on the tax benefits or incurring a stiff penalty.

Once you have reached the contribution limit set for your chosen retirement account, if you still have some money set aside that you wish to invest for retirement, your best option will be to diversify your retirement account into various other portfolios and investment options.

Contribution limits change regularly, usually on an annual basis, meaning you have to keep updated on the annual contribution limits of the following year to make the best of the available tax benefits offered by 401(k) plans and Traditional and Roth IRAs.

IRA Contribution limits

According to the latest publication on contribution limits towards retirement savings, in 2023 the contribution limit for IRA accounts is $6,500 for younger investors, up from $6,000 in 2022. The catch-up contribution for individuals that are 50 or older remains at $1,000 for both 2022 and 2023.

If you make less than $6,000 in 2023, you will not be allowed to supplement your contributions using any other sources. In other words, whatever salary you earn will be your maximum contribution limit.

401(k) Contribution limits

The contribution limit for 401(k) accounts is significantly higher than that of IRAs sitting at $22,500 in 2023, up from $20,500 in 2022. Older individuals aged 50 and older will qualify for an additional $7,500 for catch-up contributions in 2023 compared to just $6,500 the previous year.

401(k) contributions are further complicated by the need to consider limits set on employer-sponsored plan contributions. In 2023, employer contributions cannot be more than $66,000 compared to $61,000 in 2022.

If the employee earns less than the employer limit then the contributions can be 100% of the employee’s salary.

Eligibility

No, all investors will be able to open an IRA or a 401(k) account because of the specific eligibility rules set by the IRS. Consider the following 401k and IRA difference:

ira Eligibility

If you wish to make contributions towards an IRA, you must have earned income in that year. The following qualify as earned income:

  • Salary

  • Wages

  • Bonuses

  • Tips

  • Self-employment income

You cannot use pensions, annuities, unemployment benefits, Social Security benefits, or investment income as earned income.

A spouse is allowed to fund an IRA for their partner who does not have any source of earned income. This is referred to as a spousal IRA and is another way for married couples to take advantage of the many tax benefits of IRA accounts.

401(k) eligibility

An individual is only eligible for a 401(k) account if their employer offers one. In other words, this is not the type of retirement account that unemployed or self-employed investors can consider.

Most employers offer a 401(k) plan to employees that are older than 21 years and have served at the company for at least one year.

While the IRS allows some flexibility regarding these rules, they cannot be more restrictive than the stated guidelines.

In this regard, a company is allowed, for example, to lower the minimum age for a 401(k) to 18 years old but they cannot raise it to 23 years old or ask for additional years of service before an employee becomes eligible.

Other Important Considerations

One of the advantages of an IRA vs 401(k) is that with an IRA, there is a lot more flexibility in terms of how one manages the account, such as:

  • Even unemployed or self-employed individuals can open an IRA

  • You can choose any IRS-approved bank, financial institution, credit union, or brokerage firm to be the custodian of your IRA

  • An IRA can be made up of a diversified portfolio that includes various assets, such as mutual funds, bonds, stocks, exchange-traded funds, or even precious metals

With a 401(k), although you get to enjoy higher contribution limits, you have to contend with a lot of restrictions, such as:

  • You have to have earned income through an employer that will offer the plan to you

  • Your employer chooses the third-party administrator that will manage your plan

  • You have very limited investment selection which in many cases only includes at least three choices of which the most common one is mutual funds

When looked at in this light it would seem that IRAs offer the better value, however, it must be noted that a 401(k) account is by far the safer option for investors who want to minimize risk as much as possible. This is perhaps the difference between 401k and traditional IRA options.

Choosing the Right Retirement Account for You

You cannot decide between a 401(k) and IRA without looking at your individual needs as an investor and taking into account, for example, the advantage of 401k vs IRA.

Consider the required minimum distributions for tax-deductible Roth IRAs and then compare that with the much higher contribution limit offered by a 401(k). Which of these benefits would be more valuable to your investment plans?

The employer matching contributions are also too sweet to ignore, especially if you are part of a higher income bracket and you still have many years to go before reaching retirement.

However, an equally solid case can be made for the ability to diversify your IRA account portfolio, especially in the face of such global economic uncertainty.

If your head is spinning trying to make the right decision between an IRA vs 401(k) plan, we have two pieces of good news that will help you sleep better.

Firstly, both of these options are excellent ways to invest your money for retirement. Whether you opt for the immediate tax benefit of a 401(k) or you go for a tax-deferred IRA account, the bottom line is you will enjoy tax benefits either way!

Secondly, you do not have to restrict yourself to choosing either one or the other. if you have the funds and you are eligible for both an IRA and a 401(k) why not go for both retirement accounts? This way you will enjoy doubling the benefits while further diversifying your portfolio.

Having said this, if you take the second option and after a few years decide that you would rather stick to just one of them, it is a simple thing to conduct a 401(k) to IRA rollover. In other words, your decision today is not set in stone.

Final Word

If you have not yet decided on your retirement savings, time is running out! Read the guidelines highlighted in this article and take the first important steps toward achieving your financial goals. Consider all the 401k and Roth IRA differences we discussed and make your choice.

Frequently Asked Questions

Is a 401k a Roth IRA?

Compare IRA to 401k. In a way, a 401(k) can be regarded as an IRA with the only difference being that it is an employer-sponsored plan rather than an individual retirement account which means some of the important rules will be different.

However, if you are making an important investment decision then it is important to carefully consider these differences because they may have a huge impact on how well your retirement account performs over time. In other words, you need to ask yourself how is a 401k different from an IRA.

Does Contributing to a Retirement Account Reduce Your Taxable Income?

If you contribute to a 401(k) account then yes, it will reduce your taxable income because you will be taking money from your salary before your income taxes have been deducted. This is one of the benefits of 401k vs IRA.

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