401(k)s vs. IRA Variations: Which Is the Better Choice for You?

There are many options when it comes to saving for retirement. Your new employer might have mentioned setting up a 401(k) account after they hired you. You might have heard a friend or relative talking about their individual retirement accounts (IRAs) over dinner. How can you know which retirement plan is right for you?

Your employer, income, and personal preferences determine which retirement plan suits you. Learn more about 401(k) plans and IRAs, and start saving for the future today.

What Is an IRA?

An individual retirement account is a tax-advantaged retirement account that helps you save money for retirement. Any person with earned income can open and contribute to an IRA. You don’t have to have an employer to participate in one. There are different types of IRAs, including the following:

• Traditional IRA: This IRA account offers tax-deferred growth, meaning you pay taxes when you make a withdrawal from the account. Contributions could be fully or partially deductible, depending on your filing status or income.
• Roth IRA: This IRA account offers tax-free growth. You only pay taxes when you make unqualified withdrawals during retirement. Unlike traditional IRAs, you make Roth IRA contributions with after-tax dollars.
• Simplified Employee Pension (SEP) IRA: This account allows employers to contribute to traditional IRAs established for employees. Businesses of all sizes can set up SEP IRA accounts.
• Savings Incentive Match Plan for Employees (SIMPLE) IRA: This account allows employees and employers to contribute to traditional IRAs established for employees. The difference between SEP and SIMPLE IRAs is that employees can contribute under SIMPLE IRAs.

What Is a 401(k)?

A 401(k) is a retirement plan offered by employers. If the company you work for offers a 401(k) plan, you can choose to have a certain amount of money deducted from your paycheck each period and deposited into your 401(k) account.

Contributions to a 401(k) are pre-tax, meaning you don’t pay income or other taxes on them now. Instead, you pay tax on the money in a 401(k) when you withdraw it during retirement. Depending on your income now and your income in retirement, contributing to a 401(k) plan can help to lower your overall tax bill.

What sets a 401(k) apart from other investment and savings options is that you can only access one if your employer sponsors a plan. If you are self-employed or don’t have a full-time job, you likely won’t have access to a 401(k). Some companies do not offer 401(k) plans, even for full-time workers.

If you work for a government agency or nonprofit, there is a good chance you are taking advantage of a 403(b) instead of a 401(k). These retirement savings accounts are very similar to 401(k)s, except they’re available for public agencies and nonprofits and are exempt from some administrative costs that apply to 401(k) plans.

How IRAs Compare to 401(k)s

The various IRA types have similarities and differences to 401(k)s.

1. Traditional IRA vs. 401(k)

When it comes to taxes, a traditional IRA is a lot like a 401(k). You can deduct the total of your contributions to a traditional IRA from your taxable income for the year when you make the contributions. When you are ready to start withdrawing from a traditional IRA, you pay income tax on the amount you withdraw.

However, traditional IRA contributions are typically lower than 401(k) contributions. Unlike 401(k) accounts, which are employer-sponsored, you must obtain a personal account through financial institutions like banks and investment firms. Since there are no employer-match contributions, you’re in charge of your contributions to traditional IRA accounts.

If you have a traditional IRA, you can contribute to it until you are 70 ½ years old. You also must start taking distributions or withdrawing money from a traditional IRA by the age of 70 ½.

2. Roth IRA vs. 401(k)

Roth IRA accounts allow tax-free growth on your contributions. This means you pay taxes on the money you put in the account and can withdraw during retirement without further taxes. There are also no tax deductions for contributions you make to the account. Retirement distributions from 401ks are subject to standard income tax rates.

You can withdraw contributions — not earnings — from your Roth IRA without penalties, and 401(k)s do not offer that flexibility. Roth IRAs typically have income eligibility limits for contributions, which is not the case for 401(k)s. Finally, employees can contribute to their Roth IRA accounts, unlike 401(k)s, which are employer-provided and offer employer-match contributions

3. SEP IRA vs. 401(k)

Simplified Employee Pension IRAs are an option for businesses of any size, as well as self-employed individuals. The employer makes the contributions. Generally, employees cannot contribute. On the contrary, 401(k)s allow contributions from all parties.

SEP IRA contribution limits are higher than traditional and Roth IRAs but generally lower than 401(k)s. However, there is a similarity. SEP IRA contributions are tax-deductible like 401(k)s.

4. SIMPLE IRA vs. 401(k)

SIMPLE IRAs are employer-sponsored retirement plans for businesses with 100 or fewer employees. Similar to 401(k)s, employers can match employee contributions, but contribution limits are typically lower than those of 401(k)s.

SIMPLE IRAs also have simpler administrative requirements than 401(k) plans, making them easier for small businesses. There are lower administrative costs, flexible employer contribution options, no discrimination testing, and fewer intensive reporting requirements.

Another general difference between IRAs and 401(k)s is that IRAs allow you to choose from various options, including savings and investment choices. 401(k)s are limited to what your employer offers in the plan.

Contributing to a 401(k)

Generally speaking, you contribute a percentage of your gross salary to a 401(k). However, there are limits to the total amount you can contribute annually. The contribution limit for 2024 is $23,000. People over the age of 50 can contribute an extra $7,500 per year to their 401(k) plans to help them catch up on retirement savings.

Since your employer administers 401(k) plans, they are responsible for withholding the money from your paycheck and depositing it into your account. If you want to change how much you contribute to your plan each pay period, you need to contact the department at your employer that handles employee benefits.

401(k) and Employer Match

Although you as an individual are limited in your annual contributions, there is a way to increase the amount in your 401(k). Some employers offer to match contributions to a plan, usually up to a certain percentage of an employee’s salary. The amount of the match varies based on the company. An employer may match every dollar you contribute up to 3% of your salary. Others may offer a match of 50 cents for every dollar contributed up to 6% of your salary.

The employer match is optional, so each company decides its match rules. Occasionally, a company won’t match contributions at all. Others may offer a match, but only to employees working there for a specified period.

Contributing to an IRA

Like a 401(k), you can’t contribute as much as you want to an IRA during the year. For 2024, the contribution limit is $7,000 per year. People over the age of 50 can contribute an additional $1,000. The annual contribution limit is per person. If you open a traditional and Roth IRA, the savings apply to the combined accounts, not individually.

Since you are responsible for opening and contributing to an IRA, you can decide when and how much to deposit into your account. You can set up monthly deposits or contribute every quarter. You can also make the full contribution to your account at the beginning of the year.

Accessing the Money in a 401(k) Plan

The money you contribute to a 401(k) plan is meant to be there for you in retirement. That means there are penalties if you withdraw funds early, usually before age 65. If you take money out of your 401(k) before retirement age, you’ll need to pay income tax on the amount you withdraw, plus a 10% penalty tax.

Some 401(k) plans allow for hardship withdrawals before retirement age. You might not pay a penalty on hardship withdrawals, but you pay income tax. To qualify for this type of withdrawal, your employer must recognize that you have an immediate and heavy financial need.

You might also be able to borrow from your 401(k), usually up to 50% of the account balance or $50,000. You pay the loan back to the account, with interest, over time, often for five years.

When you reach the age of 65, you can withdraw your retirement savings without incurring penalties. The income is taxable unless you use a tax-free alternative like a Roth 401(k). Once you reach age 70½, you must withdraw the Required Minimum Distribution (RMD) level each year. RMD is the minimum amount the government requires you to withdraw from an account.

Accessing the Money in an IRA

The amounts you contribute to an IRA are meant to be used in retirement. There are penalties if you withdraw from an IRA before the age of 59 ½. Typically, you’ll have to pay a 10% penalty tax on the amount you withdraw, and if the money comes from a traditional IRA, income tax on the amount.

There are exceptions to the rule. Since you’ve paid tax on contributions to a Roth IRA, you don’t have to pay income tax or the penalty tax when you withdraw your contributions. You can also avoid the penalty tax if you withdraw from an IRA to pay for education, your first home, or certain medical expenses.

Much like 401(k)s, once you reach the age requirement to withdraw, you can begin using your IRA without any tax penalty, but this will be treated as taxable income unless you have a Roth IRA. Once you reach age 70 ½, you must withdraw at least the RMD from your IRA like you would with a 401(k).

What Happens to a 401(k) Plan When You Leave a Job?

Leaving a job means you won’t be able to contribute to that 401(k) anymore, but that doesn’t mean you will lose access to the money you saved. You have a few options when you change jobs.

You can transfer the money in your old 401(k) into the plan offered by your new employer if the new employer offers a retirement plan. You can leave the money alone, letting your investments and savings grow over time. If you choose this option, you might have to pay the administration fees that your employer was paying. Finally, you can roll the money into an IRA.

Can You Contribute to a 401(k) and an IRA?

After looking at the differences between a 401(k) and an IRA, you might conclude that both look like good choices, and you’re not sure how you’ll narrow it down. The good news is you don’t have to choose between one or the other. If you are eligible for a 401(k) plan through your employer, that doesn’t necessarily mean that you can’t also open and contribute to an IRA.

You can contribute to a traditional IRA with a 401(k), but the amount you can deduct might change based on your income. If you have a retirement plan at your job, are single, and earn less than $77,000, you can contribute to a traditional IRA and deduct the full amount of your contribution. If you earn over $87,000 and have a retirement plan at your job, you can still contribute to a traditional IRA, but you can’t deduct the amount from your taxable income. If you earn between $77,000 and $87,000, you can take a partial deduction. There are also income limits for married couples who have retirement plans through their jobs.

Your adjusted gross income, but not your retirement plan status, also determines whether you can contribute to a Roth IRA during the year. Individuals who earn less than $146,000 per year and married couples who file their taxes together and earn $230,000 or less can contribute to a Roth IRA. If that’s the case for you, you can either contribute to a 401(k) if your job offers one or open a traditional IRA.

Making the Ideal Choice

If you want to save as much as possible for retirement, it makes sense to contribute to a 401(k) offered through your employer and to an IRA. If you can make the maximum contributions to both accounts, you are setting yourself up for the best results when saving for the future. However, not everyone can save the maximum aggregate contribution amount per year for retirement. In those cases, you’ll want to look closely at your options before deciding where to put your money.

Since you can have a 401(k) and an IRA, which makes more sense to open and contribute first? If your employer offers a 401(k) and will match your contributions, it’s usually a good idea to contribute what you can to that account up to the matching limit. Getting the employer match on a 401(k) is like earning bonus money. If they are offering it, it’s usually in your best interest to take it.

If your employer has a 401(k) but doesn’t match contributions, it’s often best to focus on contributing to an IRA first. You usually have more investment options and flexibility for making contributions with an IRA than 401(k).

Whether you contribute to a traditional or Roth IRA depends on your income and what you expect your tax bill to be like in retirement compared to today. If you think you’ll be in a higher tax bracket in your retirement years, contributing to a Roth IRA and paying the taxes now rather than later might make the most sense. If you think you’ll be in a lower tax bracket during retirement, a traditional IRA might be a better fit.

Focus on contributing to a 401(k) or an IRA is a smart way to prepare for the future. Retirement might seem like years or even decades away, but the sooner you start planning for it, the better prepared you’ll be when it does arrive.

Trust Mid Penn Bank for Investment Consulting Services

IRAs and 401(k)s are tax-advantaged retirement accounts, but there are differences. The ideal option depends on several factors, such as the potential of earning more in the future. In certain instances, you can contribute to an IRA and 401(k), but your income will determine how much deduction you can make. Considering the complexity of these financial arrangements, you should consult professionals for tailored advice.

Mid Penn Bank offers investment consulting services to clients in Pennsylvania and New Jersey. Since our inception in 1868, we have provided strategic solutions, leveraging industry knowledge and experience. Our investment professionals are ready to listen to your needs and help you achieve your financial goals. Contact us today to learn more about our services and your retirement planning options.

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