401(k) vs. IRA: What’s the Different and How to Choose

If you’ve started thinking about investing for retirement, you’ve probably come across the “401(k) vs. IRA” debate. These aren’t figures in an algebra equation. They’re different types of retirement accounts that can help you save for your future while gaining tax advantages. The name of the 401(k) comes from a section of the IRS code, while IRA stands for “Individual Retirement Account.”

When you’re deciding whether to open a 401(k) vs. IRA, it’s helpful to know what these accounts are, how they’re similar and different, and how each of them can help you achieve your retirement goals. (Pro tip: it might make sense to have both!)

401(k) vs. IRA: The Similarities

First, let’s go over the similarities between these two popular retirement accounts. 

Investment Account Types

One common misconception for new investors is that simply having a 401(k) or IRA automatically means that you’re investing in the stock market. However, 401(k)s and IRAs aren’t investments themselves: they’re just accounts where you can hold investments.

💡 You can think of them as the wallet, not the cash.

Once you open a 401(k) or IRA, you’ll need to decide what kinds of investments to purchase inside your account. If you skip the asset allocation step, your money might just be sitting in cash inside the account. It wouldn’t be growing at all! Later, I’ll touch more on the different kinds of investment choices you may have in a 401(k) vs. IRA.

Retirement Tax Advantages

401(k)s and IRAs are both types of tax-advantaged retirement accounts. 

With a regular taxable investment account, you invest money you’ve already paid income taxes on. Every transaction you make is a taxable event, so you’re getting taxed on both sides (contribution and sale/withdrawal).

In a tax-advantaged retirement account, you’ll only be taxed on one side. If you choose a traditional pre-tax 401(k) or IRA, you’ll make tax-deductible contributions. You’re funding the account with money that the government won’t tax that year. You’ll only pay taxes when you withdraw the funds in retirement. 

There’s also the option to choose a Roth, or post-tax, version of a 401(k) or IRA. This works the opposite way: you’ll pay regular income taxes on your money the year you contribute it. You won’t be taxed when you withdraw it in retirement.

📘 Learn more about the difference between traditional and Roth accounts.

Restrictions on Withdrawals

Because 401(k)s and IRAs are meant to encourage retirement saving, neither of them makes it easy to just get that money out whenever you want it. You’ll face taxes and penalties if you try to withdraw funds before age 59 ½, unless you qualify for an exception. 

☝ A Roth IRA is unique in that you can always withdraw your contributions without penalty; you just can’t withdraw any profits you’ve made. For instance, if you’ve contributed $50,000 to a Roth IRA and it’s grown to be worth $75,000, you can withdraw the $50k of contributions but not the $25k of profits.

401(k) vs. IRA: The Differences

When you’re trying to decide on opening a 401(k) vs. IRA, the differences are more important than the similarities, so let’s dive in! 

Account Management & Eligibility

The biggest difference between a 401(k) vs. IRA is who manages the accounts and who is eligible to get them.

A 401(k) is an employer-sponsored retirement account, so you can only get one if your employer offers one and you meet their employee participation standards (e.g. you may have to work at the company for a certain amount of time before becoming eligible). The company chooses the 401(k) provider and sets up the plan.

An IRA is an account you open and manage as an individual. Anyone who is under the age of 70 ½ and is earning taxable income can open and contribute to an IRA. That means you can invest in an IRA even if you’re self-employed or have a side gig; your account isn’t tied to a company you’re working for. You can open your own IRA at many popular brokerages, including Fidelity, Vanguard, Wealthfront, and others.

Contribution Limits

Both accounts limit how much you can contribute in a year, but the limits for a 401(k) are much higher. They also both allow for catch-up contributions after age 50. 

As you can see, if you want to invest more than $6-7,000 a year for retirement, an IRA alone wouldn’t be enough.

Investment Selections & Fees

The average 401(k) plan offers 8-12 investment choices^[1], which are usually some combination of mutual funds. They might have a large-cap stock fund, a small-cap stock fund, a bond fund, a target-date fund, and so on, with a mix of riskier or more conservative investments. 

An IRA gives you a much broader range of choices. Within an IRA, you can purchase almost any type of investment, including:

• Index funds & mutual funds
• ETFs
• Individual stocks
• REITs (real estate investments)
• Bonds
• Annuities

In short, an IRA gives you a lot more freedom to choose your investments, while a 401(k) locks you into whatever packages your company picks.

💡 If your employer’s 401(k) offerings have high fees or don’t meet your investment objectives, you might want to stick to an IRA or open an IRA to supplement your 401(k).

401(k) Employer Matching

Depending on your employer, matching can be an incredibly significant benefit of a 401(k). Essentially, your company will add extra money to your 401(k), up to a certain percentage of your salary and contributions. 

Some companies don’t offer a match, but for the ones that do, it’s an extra incentive to contribute to the plan and stay at the company. That’s because matches can be subject to different vesting schedules, which means if you leave the job before your matches have fully “vested,” you’ll only get to keep your own account balance and possibly a certain percentage of the match. 

☝️ As long as you stay at the company long enough for the match to vest, it’s free money that you definitely don’t want to pass up!

How to Start Investing in a 401(k) and/or IRA

Now that we’ve reviewed the similarities and differences of a 401(k) vs. IRA, it’s time for action. Where should you start in order to maximize the advantages of these accounts?

Here are the steps I recommend:

1. Review your employer’s 401(k) options, if applicable. The biggest things to look for are (A) what funds are available for investing inside the plan and (B) what the expense ratio is for each fund since you’ll want to avoid ones with high expense ratios. If you don’t have an employer who offers a 401(k) or their options don’t work for you, skip straight to opening an IRA.
   
2. If your employer offers a 401(k) match, start by contributing just enough to get the match. Like we talked about above, if they match 50% of a 6% contribution, you should set your 401(k) contribution at 6% to get the full match. As long as the expense ratios aren’t higher than the match percentage, this is free money. Talk to your HR department if you have questions about setting up your 401(k).
   
3. When you’re contributing enough for the match and still want to invest more, open an IRA next. You can easily do this online with a brokerage of your choice. Max out your IRA if you’re able to. If your employer doesn’t offer a 401(k) match, funding an IRA should be your step 1. If your 401(k) is traditional, consider opening a Roth IRA to go with it, to maximize the advantages of both types.
   
4. Once you’ve maxed out your IRA or have gotten on track to do so, you can revisit and increase your 401(k) contributions if you still have more money you’d like to invest. Contribute as much as you feel comfortable. 

5. If you have any income from self-employment, you can also explore other account alternatives like a solo 401(k) and SEP-IRA.

The absolute best-case scenario is to be able to max out your IRA and your 401(k), but don’t feel bad if that just isn’t possible. Only 13% of 401(k) participants in a 2018 Vanguard survey were maxing out their contributions, and many of those people were older and later in their careers^[2]. The most important thing is just to do what you can. It’s your financial journey and you don’t need to compare it to anyone else’s. Focus on your goals and look forward to the future!