IRA vs. 401(k): Which retirement plan is right for you?

While there are many ways to build your retirement savings so that you can have the post-career life you imagined, two accounts are designed to help you with this goal: an individual retirement account (IRA) and a 401(k).

Each of these savings plans have unique tax considerations, strengths and limitations. Understanding the IRA vs. 401(k) tradeoffs can help you determine which works best for you and which one will allow you to pursue your retirement goals, such as spending more time with family, supporting your community and donating to charities.

To supercharge your savings even more, you can use both types of accounts. In fact, Thrivent's Retirement Readiness Survey^* found that among those nearing retirement, 42% intend to rely on a mix of assets such as a 401(k), IRA, personal savings, and Social Security benefits.

In this article, we'll cover:

• What is an IRA?
  
  • Traditional vs Roth IRA
• What is a 401(k)
  
  • Traditional vs Roth 401(k)
• The primary differences between an IRA & 401(k)
  
  • How to access
  • Eligibility
  • Contribution limits
  • Investment options
  • Loans
  • Withdrawal rules & requirements
  • Required minimum distributions (RMDs)
• IRA vs 401(k) at a glance
• Is it better to contribute to a 401(k) or IRA?

Individual retirement accounts, or IRAs, are tax-advantaged retirement savings vehicles meant to bolster your current savings with earnings that compound over time. Traditional and Roth are two of the most common types of IRAs.

A traditional IRA is funded with pretax, or "tax later" dollars. Any taxes you pay are deferred until you begin taking distributions. Your contributions are tax deductible if you and your spouse don't participate in an employer-sponsored plan. If either of you does participate in an employer plan, your contributions are tax deductible as long as your income is below certain thresholds.¹

This option may be beneficial if you believe you are currently in your peak earning years and believe you may be in the same or a lower tax bracket in retirement.

A Roth IRA is funded by money that you've already paid taxes on—also known as after-tax dollars—so distributions of your contributions are tax-free at any point. While there is no tax deduction for Roth IRAs, your earnings grow deferred in the account, and you never will pay income taxes on those earnings if you are making a qualified distribution.²

A Roth IRA may be advantageous if you believe you are not in your peak earning years and think you may be in a higher tax bracket in retirement.

A 401(k) is the most common type of employer-sponsored retirement plan. It helps employees save for and invest in their retirement in a tax-advantaged way.

When you sign up to participate in a 401(k), you opt to have a specific percentage of your paycheck automatically directed into the plan. Your employer has the option to match some or all of your contributions as an employee benefit, helping to give your savings a boost. Over time, your savings will compound and grow tax-deferred.

Many employers have begun offering Roth 401(k)s, which differ from traditional plans in a major way. Simply put, Roth 401(k)s work in a similar way to Roth IRAs. While you contribute pretax dollars through payroll deductions to a traditional 401(k), your contributions to a Roth 401(k) are made with dollars you've already paid taxed on, so you won't have an additional tax liability when you take distributions.

Additionally, your earnings from a Roth 401(k) will grow tax-free, and if you are making a qualified distribution, you never will pay taxes on those.²

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Though they are both accounts to help save for retirement, IRAs and 401(k)s differ in seven primary ways:

If you want to open an IRA, you work directly with a financial institution that offers them, such as a brokerage firm or a bank.

You only can access a 401(k) through an employer that offers one as a benefit. You then fund it by making contributions through payroll deductions.

To contribute to an IRA, you or your spouse must have earned income. This includes wages, salaries, tips, bonuses, commissions and earnings from self-employment. However, Roth IRAs have income limits to participate.

If you make between the maximum modified adjusted gross income (MAGI) listed, you can contribute to a Roth IRA but it will be a reduced amount. If you make equal to or more than the maximum limit listed, you can't contribute anything to a Roth IRA.

You must be working at a company to contribute to a 401(k). Some employers allow new hires to enroll in their plan immediately, but others may require employees to wait up to a year to participate.

The IRS sets contribution limits for retirement plans each year. And, as an additional boost for people age 50 or older, catch-up contributions are able to made beyond the standard limit.

IRAs have much lower contributions limits than 401(k)s.

• 2023 contribution limit: $6,700
• 2024 contribution limit: $7,000
• Catch-up contribution limit: $1,000

• 2023 contribution limit: $22,500
• 2024 contribution limit: $23,000
• Catch-up contribution limit: $7,500
  

While both IRAs and 401(k)s offer professional investment options, IRAs often have greater flexibility.

An IRA portfolio can include a variety of investments, like stocks, bonds, mutual funds, certificates of deposit (CDs), real-estate investment trusts (REITs) and money market funds.

Most IRAs allow you to choose your investment options, or you can leave the decisions to a professional at the financial institution you choose.

Portfolio options for a 401(k) generally are limited to the investments the plan provider chooses. These commonly include mutual funds and company stock. (Some plans do enable investors to access a wider variety of choices through a self-directed brokerage account, however.)

Some retirement plans offer loans that account owners can pay back over time.

The option to borrow funds and then pay back is not available for IRAs.

Some providers allow 401(k) participants to borrow from their plans, though before doing so consider the full list of benefits and drawbacks: The pros & cons of borrowing from 401(k) plans

Distribution rules of IRAs and 401(k)s are dependent on if you have a traditional or Roth version:

• You can withdraw penalty-free as early as age 59½, with your withdrawals taxed at your current income.

• If you withdraw funds before 59½, you may face a 10% penalty unless you qualify for an exception. Exceptions include to pay health insurance premiums after a job loss, to purchase a first home, to help pay for the birth or adoption of a child, and to help pay qualified education costs for you or a family member. You can view the full list here.

• You can withdraw penalty-free at age 59½, if you leave your job, or experience a disability. Your withdrawals will be taxed at your current income.

• If you withdraw funds before 59½, you may face a 10% penalty unless you qualify for an exception.

For both a Roth IRA and a Roth 401(k), withdrawals of contributions are tax and penalty-free at any time. Earnings are tax-free and penalty-free if the account is at least five years old and one of the following requirements is met:

• You're at least age 59½.
• You're disabled.
• The money is being paid to a beneficiary.
• Up to $10,000 for a first-time home purchase

A Roth 401(k) also offers this perk:

• You can take a partial distribution that draws from both your contributions and earnings (prorated), unlike a Roth IRA, which draws from your contributions first.

An RMD is the minimum amount of money you must withdraw from a tax-deferred retirement plan after you reach a certain age.

Traditional IRAs and 401(k)s will require you to take RMDs and pay taxes on the distribution.

• If you turn 73 before 2033, your RMD age will be 73.
• If you turn 74 after 2032, your RMD age will be 75.

If you're still working at your RMD age and your plan allows it, you may be able to delay taking RMDs. The IRS applies a formula to determine the amount of each annual RMD. Additionally, the IRS requires those who own 5% or more of a company to take RMDs once they turn 73. This age increases to 75 in 2033.

Roth IRAs do not have RMDs for the IRA account owner, although beneficiaries of a Roth IRA may have specific distribution requirements.

Starting in 2024, there will be no RMD requirement for Roth 401(k)s. Prior to that, these accounts had the same RMD requirement of traditional 401(k)s. 

The answer depends on your financial goals and personal variables, like your age, work status and investment horizon. For example, if you work for a company that offers a 401(k) match, you could earn essentially free money by contributing to a 401(k). Now, if you've changed jobs where you had a 401(k), you may want to consider rolling your account into an IRA.⁴

Remember that both accounts also can work together. Consider funding an IRA if you've maxed out your 401(k) contributions or met your company match but want to save more for retirement. In addition, owning retirement accounts that are taxed differently, like a 401(k) and a Roth IRA, can help diversify your tax liabilities. Just keep in mind that if you or your spouse contributes to a 401(k) and a traditional IRA at the same time, the deduction you can claim on your federal income tax return may be limited.¹

The ins and outs of retirement accounts can be a lot to sort through. For personalized guidance, insight into different savings strategies and setting yourself up for the retirement you envision, connect with a financial advisor.