Updated for the 2024 tax year.
So you’ve made the decision to start planning for retirement. Now comes the next step: Where are you going to put that money?
You’ve got a lot of options, but the two biggies are a 401(k) and an individual retirement account (aka IRA). They’re both investment accounts, they both have tax advantages, and which one’s right for you depends on a lot of things. (Hint: The answer could be “both.”) Here’s the definitive rundown.
The quick and dirty difference between a 401(k) and an IRA
A 401(k) is an employer-sponsored retirement plan. (Read: You must have a job with a company that offers this benefit in order to participate … and your company’s not required to offer it, by the way.) You contribute part of your paycheck, your money gets invested, and, come retirement, you keep whatever returns your contributions have earned you — with some options for tax breaks along the way.
An individual retirement account (IRA) is a retirement account you set up for yourself. With an IRA, you put in money, and when you retire, you get to keep whatever returns you’ve earned … and IRAs also come with some sweet tax breaks. (PS: Technically, the IRS calls this an “individual retirement arrangement,” but in real life, everyone calls it an account.)
The other main difference between a 401(k) and an IRA is the contribution limit. With a couple of exceptions, you can contribute way more to a 401(k). The limit for 2024 is $23,000 ($30,500 if you’re 50 or older). The limit for most IRAs is $7,000 ($8,000 if you’re 50 or older).
What is a 401(k)?
The 401(k) is a relatively new invention. It was born just 40 years ago in 1978, when Congress made some sweeping changes to the tax code, as an “insignificant and supplementary” addition to existing employer retirement plans.
At the time, old-school pension plans were still the retirement-savings vehicle of choice. In those (also called “defined benefit plans”), employers guarantee you a certain amount of money (gold watch optional) upon your retirement, usually paying it out monthly or quarterly for the rest of your life.
Truth be told, employees probably still would prefer a pension, but employers have since jumped on the opportunity to save themselves some scratch. (Not that pensions are perfect for employees — employers have proven that they can’t guarantee paying out the promised levels, and even in pensions’ heyday, not even half of private-sector workers had them.)
Depending on your line of work, your employer might not offer a 401(k) but instead something very similar, like a 403(b) plan (offered by non-profit employers), 457 plan (typically available to state and local government employees) or Thrift Savings Plan (or TSP, the federal government’s offering for its employees).
How does a 401(k) work?
Your employer enrolls you in their plan. This often happens automatically, defaulting to small amounts, but sometimes you have to ask to be enrolled. You’ll have the option to decide how much you’d like to contribute — whether that’s a set dollar amount or a percentage of your salary. Your employer deducts that amount from your paycheck and directs the funds into your investment account.
Each plan has its own limited list of available investment options for you to choose from. If you don't choose your own investments for those contributions to go into, the plan always has a default investment option. (That option’s intended to be appropriate for you ... but may or may not end up being a good fit for your situation, FYI.)
The two main kinds of 401(k) are traditional and Roth. With traditional 401(k) contributions, that money comes out of your paycheck and goes into your plan pre-tax. You’ll be taxed when you withdraw it in retirement — any money you pull out, whether it came from your own contributions or the earnings from your investments, will be considered part of your gross income on your tax return.
With Roth 401(k) contributions, you pay taxes on the contributions (through your paycheck) before you put them into the plan — but then you can withdraw your money in retirement tax-free … as long as your account is over five years old and you’re older than 59½. (Note that only about half of 401(k) plans offer a Roth option, according to the Transamerica Center for Retirement Studies.)
Upsides of a 401(k)
High contribution limits, few income limits. For 2024, the IRS will let you contribute up to $23,000 (or $30,500, if you’re 50 or older) into a 401(k), and there are rarely income caps to be eligible. The exception: In some 401(k) plans, “highly compensated employees” — those who make more than $155,000 per year, are in the top 20% of earners in the firm, or own more than 5% of the company — might not be allowed to contribute the full annual amount if other participants aren’t contributing enough. Check with your HR team to see whether this would affect you.
Your employer automatically deducts your contribution from your paycheck. Which means you never even see that money. Which means you never have to deal with the temptation of spending it. And if you never feel like you own that money in the first place, you should have an easier time living without it — until you retire.
Your contributions go into a traditional 401(k) before they get taxed. This is one of the key benefits of using a traditional 401(k) to save for retirement: Not only are you saving the money you put away, but your taxable income is also reduced by the amount you’re saving, which means a lower tax bill come April.
To break this down using a pre-tax calculator, let’s say you’re single, earning $75,000 a year (putting you in the 22% marginal tax bracket), and contributing $7,500 a year to your 401(k). That brings your taxable income down to $67,500 — and given an effective tax rate of 12.07%, you’d save $1,650 in taxes.
(If you have the option for a Roth 401(k), you won’t save with a tax deduction — the tax benefits come later when you get to withdraw the money tax-free, even when part of the money comes from investment earnings!)
Many employers help fund your retirement with a 401(k) match. A common offer is 50 cents (or more) for every dollar you save, up to a certain amount of your income. Definitely take that offer, if it comes your way, and contribute at least the minimum to grab that full company match.
Downsides of a 401(k)
Withdrawal rules. On the other side of the saving equation is withdrawing. A 401(k) is a sweet deal … but you do have to abide by certain rules when it comes to drawing down your savings. Mainly, you have to be older than age 59½ when you withdraw. Otherwise, the money you take gets taxed and hit with a 10% penalty fee. Plus, most 401(k) plans won’t even let you take money out if you’re still an employee with the company, unless you can prove you’re going through a “hardship.” If they do allow you to withdraw, you usually won’t be able to contribute to the plan for a set period of time afterward.
Of course, there are some exceptions. For example, a beneficiary can withdraw funds without a fee if the 401(k) holder dies. You can also tap your own 401(k) early, penalty-free, if you become disabled, need the funds to cover unreimbursed medical expenses exceeding 10% of your adjusted gross income, or leave the employer that sponsors the plan in the year you turn 55 or older.
Huge penalties for not withdrawing on time. Proving that timing really is everything, you can’t wait too long to start making withdrawals. In fact, you’re required to take out a certain portion of your 401(k) every year starting in the year you turn 72 (73 if the account owner reaches age 72 in 2023 or later), unless you’re still working. That’s called a required minimum distribution (RMD). Your age and account balance determine your RMD — and if you fail to make the proper withdrawal in time, you can get hit with a hefty penalty. So if your RMD should have been $10,000 one year, and you miss making that withdrawal, you’d owe $5,000 — and that’s on top of whatever taxes you’d pay.
Administrative fees. These are more commonly called “401(k) fees” (clever name, we know). By any name, only 27% of people realize they’re paying them, according to one survey — but 401(k) administrative fees average 0.20% to 5.0%, according to 401(k) plan rater Brightscope.
Investment fees and options. You don’t have much of a say in the investment options in your 401(k), which means you may not have diversified, low-cost index funds available.
Loan fees. You can also borrow from your 401(k), but you may have to pay a fee for the privilege. On top of any fees, you’ll also have to pay yourself interest on that loan (which, yes, is better than paying it to a lender). And if you leave your job with an outstanding 401(k) loan, the loan balance must be paid in full by due date of your tax return, including extensions; otherwise, you’ll owe taxes on the balance, plus a 10% penalty if you’re younger than age 59 ½.
You stop paying in when you leave your job. Your 401(k) — or similar plan — is always tied to your employer, so when you quit, you can’t contribute to it anymore, and you’ll need to decide what to do with it. Usually, you’ll choose between four options: leaving it where it is, rolling it over to an IRA, rolling it to a 401(k) or similar retirement plan at your new job, or withdrawing funds early and paying a penalty.
What is an IRA?
An individual retirement account (IRA) is just what the name implies — an account for you alone to save in for your retirement.
Like the 401(k), you can go with either the traditional 401(k) and Roth 401(k) brand. Like traditional 401(k)s, traditional IRAs allow you to contribute tax-free if your income falls below a limit. Like Roth 401(k)s, Roth IRAs save you taxes on your withdrawals. And just like 401(k)s, you don’t pay taxes on your earnings in the account year-over-year.
You can get started with an IRA with pretty much any investment advisor (including Ellevest), bank, or broker-dealer, and you make contributions just like you deposit money into any account. To mimic the auto-saving feature of 401(k)s — and ensure you’re not tempted to spend what you plan to save — you can set up recurring payments through your checking or savings account.
Upsides of an IRA
More flexible withdrawal rules. Just like with a 401(k), you must be at least age 59½ in order to withdraw from your traditional IRA penalty-free — and you must start taking RMDs in the year you turn 72. But traditional IRAs allow a couple more exceptions for early withdrawals, including for a first-time home purchase and qualified education expenses.
Roth IRAs have way more flexibility on withdrawals. Contributions you’ve made can be withdrawn any time, tax- and penalty-free — a huge selling point for Roth IRAs. To withdraw earnings on your contributions, however, the age 59½ rule applies, and your account has to be at least five years old. The same early withdrawal exceptions for traditional IRAs apply for Roths. Also, Roth IRAs do not have RMDs — another big pro.
Potentially lower fees, and more investment options. Often, IRAs come with lower (or no) maintenance fees. And because you’re not limited to an employer’s plan, you can comparison-shop at different companies for fees and choose any investment portfolio you think gives you the best chance of hitting your goals. You’ll still pay transaction fees to buy and sell investments within your account (which you may not pay in your 401(k) plan), advisory fees charged by your investment advisor (if you decide to hire one), and “expense ratios” (fancy word for fees) charged by the firms providing your individual investments, though.
Your IRA stays with you. Your IRA stays in the same place even if you switch jobs, move to freelancing, take a career break, etc. You can keep contributing to it (up to the limit, of course) as long as you have earned income in some form. This is true even if you opened your IRA because your employer offered a payroll deduction benefit — it’s yours, whether you work there or not.
Downsides of an IRA
Income limits. Not everyone can go the Roth IRA route. There are income limits: If you are single and have a modified adjusted gross income (aka MAGI) of more than $161,000 in 2024, you are not eligible to contribute to a Roth this year. If you earn between $146,000 and $161,000, you can only make a partial contribution, meaning not the full $7,000 allowed.
Traditional IRAs don’t have income limits on contributions … but not all contributions can be deducted from your income (aka “pre-tax”). If you make too much money, you won’t get to take the deduction on all or part of your contributions on your income tax return — which means you might be making an after-tax contribution to a traditional IRA. (That would mean you'd be paying taxes going in as well as when you start withdrawing.)
If you’re covered by a retirement plan at work, how much you can contribute pre-tax (aka “deduct”) depends on your MAGI. For single filers, you can only deduct the full contribution limit if your MAGI is $77,000 or less in 2024; if it’s $87,000 or more, you get no deduction — but you can still contribute the full amount the IRS allows. If you can’t take the deduction on a contribution, you can still contribute. The earnings on your after-tax or “non-deductible” contributions still won’t be taxed until you take them out. Taxes on withdrawals get more tricky, though, because a percentage of each withdrawal will be considered not taxable, since you didn’t get that deduction up front. (Note: Some states, like Massachusetts, have different rules.)
Contribution limits. At $7,000 per year ($8,000 if you’re age 50 or older) for all IRAs you have open, the contribution limit is much lower than it is for a 401(k). (One big exception: If you’re a small business owner with a SEP IRA, the contribution limits are actually super high: $69,000 or 25% of your income, whichever’s lower.)
So … which comes first, a 401(k) or an IRA?
You have to ask yourself some questions in order to figure out how to best prioritize saving for retirement in each type of account.
Does your employer offer a 401(k)?
If not, do they offer a 403(b) or another similar account? (A lot of the same rules apply.)
Does your employer offer a match?
What costs come with each of your options?
How much do you have to invest?
What is your MAGI this year?
Why might you need to tap your retirement savings early?
If you’ve got an aggressive retirement goal or are catching up, you’re likely to want to maximize your retirement contributions by socking away as much as the IRS allows you to. For 2024, that would mean a total of $30,000 — or $38,500, if you’re age 50 or older — between a 401(k) and an IRA. If you can’t quite reach those contribution limits — because, well, you have a life to pay for today (Inhale. Exhale.) If you can’t quite reach those contribution limits — because, well, you have a life to pay for today — that’s OK. In that case, the goal is to follow the path that will let you pay the lowest fees possible in the most tax-advantaged account available to you.
For most people, that looks something like this:
First, hit your 401(k). If you’re allowed to choose the individual investments in your portfolio, try to pick low-cost funds. Invest as much as you can, up to the 401(k) contribution limit of $23,000 (or $30,500, if you’re 50 or older).
If you’ve maxed that out (go you!) and need to invest more to hit your retirement goals (or if you don’t have a 401(k) at all), open an IRA, where you can save up to $7,000 ($8,000 for the over-50 crowd).
If you can afford to save even more (and still need to in order to stay on track after hitting your contribution limits), you can open up a taxable investment account. You won’t get the same tax advantages as with a 401(k) or IRA, but investing is still a smarter move for your retirement savings than letting them sit in cash or under a mattress.
That being said, this path isn’t quite perfect for everyone. If a) you’re eligible to deduct your IRA contributions on your taxes — aka your MAGI is under the limit, and b) there aren’t any investments available for your 401(k) with expense ratios under 0.40% to 0.50%, then you should stop and talk to a tax pro (we know, we know … but you’ll thank us later). It’s possible that the following path might save you money:
If your employer offers a 401(k) contribution match, put in just enough to get the whole match. Again, choose the investments with the lowest possible expense ratios.
Once you’ve done that, switch your savings focus to an IRA, where you’ll probably have greater control over the investments you choose (and therefore the fees you’re paying). Put in as much as you can, up to the max.
Then, if you can and need to save more, switch back to your 401(k) and finish maxing it out.
If you hit that max and still want to contribute more, open up a taxable investment account (and keep killin’ it).
Whichever account you decide to go with, getting started regularly putting money into a retirement account (or accounts, your call) is one of the savviest money moves you can make.
Want to make sure you’re doing the right things with your money? Book a complimentary 15-minute call with an Ellevest financial planner to start feeling better about your next steps.