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Edited by: Kimberlee Leonard
 and Reviewed: Kimberlee Leonard

IRA vs. 401(K): Understanding Key Differences and How to Choose

Author: | Aug 17, 2023

Editorial Note: We earn a commission from partner links on Go Sifter Advisor. Commissions do not affect our editors’ opinions or evaluations.

Individual retirement arrangements (IRAs) and 401(k)s are popular savings plans that American workers invest in to save for retirement. Two of the most common types of these plans are traditional and Roth accounts. This article will cover the differences between traditional and Roth versions of IRAs and 401(k)s, and give you the information you need to decide which retirement plan is best for your unique needs.

What Is an IRA?

An IRA allows anyone who has earned income (or, in some cases, their spouse) to invest money on either a tax-deferred or tax-free basis. 

The annual contribution limit for an IRA is currently $6,500, but that amount is subject to change. In 2023, anyone over age 50 can contribute $7,500 annually. 

IRAs allow you to invest in many different types of assets, including:

  • Bonds
  • Certificates of deposit (CDs)
  • Exchange-traded funds (ETFs)
  • Index funds
  • Mutual funds
  • Stocks

In general, the more diverse your IRA portfolio, the better, as diversification can help you manage risk while opening your account to more wealth-building opportunities.

Types of IRAs

The two main types of IRAs are traditional and Roth IRAs. Let’s take a look at the differences between the two. 

Traditional IRA

A traditional IRA allows you to contribute to the account on a tax-deferred basis, meaning that you won’t have to pay any taxes on your contributions until you withdraw money at retirement age (technically age 59 ½ or older). 

Once you take money out of your traditional IRA, you start paying taxes on your withdrawals (also known as distributions). Individuals aged 73 (or 75, depending on their birth year) and older must take a certain amount out of their traditional IRAs each year. 

Traditional IRAs have restrictions on when you can access your money. If you withdraw money from a traditional IRA before age 59 ½, you will be fined a 10% early withdrawal penalty and must pay taxes on your distributions. You can avoid the early withdrawal penalty in some situations, such as when you use the money to buy a house for the first time, if you are permanently disabled or have applicable medical expenses, or for qualified higher education expenses (QHEEs). 

Your IRA contributions may be tax-deductible if you meet income requirements. IRA contributions may not be tax-deductible if you or your spouse have an employer-backed retirement plan.

Contributions to a traditional IRA will lower your adjusted gross income (AGI) for the year. A lowered AGI can affect your ability to qualify for a loan or purchase a home.

Roth IRA

With a Roth IRA, you pay taxes on your contributions annually, but your withdrawals are tax-free after retirement. Roth IRAs don’t affect your AGI but are only available to people who meet income requirements. In 2023, individuals must make less than $153,000 modified adjusted gross income (MAGI), and married couples must make less than $228,000 MAGI to be eligible to contribute to a Roth IRA.

One benefit of a Roth IRA is that you are never required to withdraw any money from the account, making it an ideal method for transferring wealth to your beneficiaries. You can also take money from your Roth IRA anytime, with no penalties. A Roth IRA makes sense if you think you will be in a higher tax bracket once you retire, as it allows you to pay taxes on your contributions at a lower rate and enjoy your distributions tax-free after retirement.

Pros and Cons of an IRA


  • Individuals of all income levels can sign up for an IRA
  • Spouses without income can also contribute 
  • Ability to invest in many different assets 
  • Can always access money (although early access may be penalized)
  • Can earn compound interest
  • Ability to transfer wealth to beneficiaries
  • Easy and inexpensive or free to set up
  • Some contributions are tax-deductible


  • Low contribution limits
  • Income levels and employer retirement plans may determine tax-deductibility
  • Early distributions may be subject to penalties
  • Traditional IRAs have required minimum distributions (RMDs)
  • Can only contribute earned income to an IRA

What Is a 401(k)?

A 401(k) is a retirement plan offered by your employer that allows you to invest part of each paycheck. One of the perks of a 401(k) plan is that many employers will match your contributions. 401(k) plans have higher contribution limits than IRAs; you can contribute up to $22,500 in 2023. Anyone aged 50 or older can make an annual $7,500 catch-up contribution.

You can invest in many different assets with a 401(k), such as stocks (including company stocks), bonds, mutual funds, and variable annuities, which allow you to pick the types of securities you wish to invest in.

As with IRAs, there are two basic types of 401(k) plans, a traditional 401(k) and a Roth 401(k). 

Traditional 401(k)

A traditional 401(k) plan allows you to defer paying taxes on your contributions until age 59 ½. You must then pay taxes on any funds withdrawn from your account. RMDs are mandatory after age 73 or 75, depending on your birth year. A traditional 401(k) plan is tax-deductible regardless of your income level.

Roth 401(k)

You must pay taxes on all contributions to a Roth 401(k) plan, but after retirement, you can enjoy your distributions tax-free. While Roth 401(k) plans currently have RMDs, they will no longer be mandatory in 2024. 

Pros and Cons of a 401(k)


  • Can contribute up to $22,500 in 2023
  • Many companies will match your contributions
  • Matching contributions can go to either traditional or Roth 401(k) accounts
  • Option to contribute automatically from your paycheck
  • After retirement, you can roll over your 401(k) plan to an IRA


  • Many companies require employees to vest, or stay with the company for a certain amount of time before allowing matched contributions to be fully owned by the employee 
  • Matching funds applied to Roth 401(k) accounts are taxable
  • Not all companies offer 401(k) plans
  • May be charged administrative fees
  • Can be penalized for early withdrawal
  • You can no longer make contributions to your 401(k) once you retire (unless you convert to an IRA)
  • If you have between $1,000 and $5,000 in your 401(k) plan after retirement, your employer must roll over your account to an IRA unless you choose to receive a lump sum or transfer the money into an IRA yourself

IRAs and 401(k)s and Compound Interest

The money in IRAs and 401(k)s can collect compound interest, increasing your wealth. Compound interest, or “interest on interest,” is money earned on the interest of your investment over time. Not only do you accumulate the amount of the interest on the principal amount of your investment, but you also receive money from the interest accumulated over previous compounding periods. 

For example, let’s say that you invest $10,000 into an account with a 5% annual interest rate. In the first year, you would earn $500 from simple interest, leaving you with a total investment of $10,500. However, the following year you would earn interest on your new balance of $10,500, leaving you with $11,025. You can see how compound interest can multiply your investment without having to take any additional actions. 

What’s the Difference Between IRAs and 401(k)s?

The main differences between IRAs and 401(k)s are that an IRA is available to anyone with earned income (or their spouse) and presents more investment options, and a 401(k) is an employer-sponsored retirement plan that allows for higher contribution limits and many companies offer matching contributions to their employees.  

401(k) plans may allow you to take out a loan, but you must repay the loan with interest. You cannot borrow money from an IRA. 

If you go bankrupt or get sued, 401(k) plans that fall under the Employee Retirement Income Security Act (ERISA) provide more protection from creditors than an IRA.

More investment choicesHigher contribution limits
Available to anyone with earned income (or their spouse)Available through employers
Traditional IRA contributions may be eligible for a tax deduction depending on your income level and whether you or your spouse are part of any employer’s retirement planContributions to a traditional 401(k) are tax-deductible
Roth IRA plans are not tax-deductible Can roll over 401(k) plan to an IRA after retirement
Can’t borrow money from an IRA401(k) plans may allow you to take out a loan
You should understand your investment options when opting for an IRA, but you can use robo-advisors to help make investment decisionsAble to make some investment decisions for you

IRAs and 401(k)s: Which One Is Better?

You don’t have to choose; if you have the funds to invest in both then that’s an effective way to maximize your investments. 

The thing is, not everyone has that kind of money available to invest. In that case, a 401(k) plan is generally the best way to make the most of your money, due to its higher contribution limits and the opportunity to receive matching contributions from your employer. 

However, if you are self-employed, or your employer doesn’t offer a matching 401(k) plan, an IRA might be your best bet. If you are employed, but your employer doesn’t offer a 401(k) plan with matching contributions, you can invest in a 401(k) plan once you hit your contribution limit for your IRA. If your employer matches contributions, you should fund a 401(k) plan first.

IRAs and 401(k)s Conclusion

An IRA is a retirement plan that anyone with earned income (or their spouse) can invest in. An IRA has a larger selection of investment choices, but capped contributions. A 401(k) is a retirement plan offered by your employer. A 401(k) plan has higher contribution limits, and many (but not all) employers provide matching contributions. 

Both IRAs and 401(k) plans offer either tax-deferred or tax-free investment growth opportunities. Both types of retirement plans offer tax breaks on contributions and the ability to invest in assets (such as stocks and mutual funds). Investing in these assets can have a higher return than investing in savings accounts or bonds.

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