All About 401(k) and IRA Savings Accounts

This information in this article is up to date through tax year 2023 (tax returns filed in 2024). 

Americans have several options when it comes to saving for retirement. Two popular options include 401(k)s and IRA savings accounts. These plans offer certain tax advantages for retirement planning.   

While these retirement plans have similarities, they’re often mixed up. Knowing the difference between the two plans is essential to determine which is best for you and your savings goals.   

What is a 401(k)?  

The 401(k) is an employer-sponsored retirement plan. Enrollment in a 401(k) is optional, but there are some things you should know if you choose to contribute to this retirement plan.   
Here’s how it works:  

  • Typically, you would contact your employer and designate which percentage of your paycheck you’d like to contribute to your 401(k). They would then take the contributions out of your paycheck before the IRS taxes your check.  
  • In 2024, the maximum amount you can contribute to a 401(k) is $23,000.  
  • Some employers offer a match program, meaning you’d have to contribute a certain percentage of your paycheck (3%, for example) toward retirement. Once you hit that percentage, your employer will double the amount you put into the account for that pay period (So, 3% becomes 6%).   
  • 401(k) distributions are tax-deferred, meaning your contributions are only taxed 60 days after you decide to pull the money out of your account. So, if you decide to change employers, you have time to transfer funds.  

What to do if my employer doesn’t offer a match program?  

If your employer doesn’t do 401(k) matches, you can still contribute to a 401(k) account without that specific perk. However, there may be a better option, depending on your retirement savings goals.  

401(k) Types  

It’s important to know which type of plan your employer provides. Each type of plan offers certain tax advantages.  

  • Traditional 401(k) -This type of 401(k) lets employees save for retirement on a pre-tax basis, so the money in this account can grow until you withdraw it at retirement age (starting at age 59 and ½).  
  • Roth 401(k) – This plan lets employees save for retirement with after-tax money, meaning you’ll have to pay taxes on your contributions. Since you’re paying taxes up front, the money in your account will grow tax-free, and you won’t be subject to taxation when you withdraw the money in retirement (as early as age 59 and ½). Starting in 2024, the Roth 401(k) will not require minimum distributions. A required minimum distribution is a specific amount of money that must be withdrawn annually from an employer-sponsored retirement plan once you turn a certain age.  

How are 401(k)s taxed?  

As mentioned above, how your 401(k) plan is taxed depends upon which plan you choose and the rules your employer has in place. It should be noted that 401(k) distributions are not taxed twice. It’s all a matter of when your contributions will be taxed depending on the type of 401(k) plan you choose.  

While retirement age is classified as age 59 and ½, you can make a withdrawal from your 401(k) account early. However, early withdrawal will result in a penalty. This is an additional taxation of 10% on top of the standard taxes you’d pay upon withdrawing.  

If you’re withdrawing from your 401(k) before the age of 59 and ½, you can report the 10% tax you’d owe using IRS Form 5329.  

How does a 401(k) withdrawal affect my tax return?  

If you withdraw from your 401(k), it’s taxed as ordinary income. You’ll have to report the taxable portion of your distribution on Form 1040. Keep in mind that considerations are different for Roth IRAs and 401(k)s. Check out this comparison table from the IRS.  

What is an IRA?  

An IRA, or an Individual Retirement Account, is another type of retirement savings account. Like the 401(k), this savings account grows your contributions tax deferred.   

However, this savings plan is not typically employer-sponsored. Instead, they’re provided by banks and investment firms. So, if your employer doesn’t offer a 401(k) plan, opening an IRA might be a viable option if you plan to save for retirement.   

Additionally, IRAs usually compound faster than 401(k)s. They also may have higher return rates depending on the account you choose. Check out how this plan works and how it differs from the 401(k) below.  

How it works:  

  • When you open an IRA account, you can invest in various assets, like CDs, stocks and bonds, and other investments.  
  • You get that same freedom when moving your investments around, too. So, if you decide to shift your money from individual stocks and bonds, you can do so without any penalty or taxation.   
  • Like the 401(k) plan, you will be subject to additional tax if you withdraw from this account early.   
  • For 2024, the maximum contribution limit is $7,000. If you’re over 50, you can contribute an extra $1,000 per year.   

IRA types  

  • Traditional IRA – This type of retirement savings account allows you to save for retirement on a pre-tax basis, meaning your contributions will only be taxed when you pull the money out of your account when it’s time to retire. After age 73, you will be required to take minimum distributions each year.  
  • Roth IRA – This savings account lets you save for retirement with after-tax money, meaning your contributions will be taxed upfront. Still, the money will grow tax-free, and you won’t be taxed when you withdraw it in retirement. Unlike the traditional IRA, you won’t be forced to take out minimum distributions. You can even transfer the money to children or other family members tax-free.  

Is a traditional 401(k) the same as a traditional IRA?  

No, with a traditional IRA, you have more investment options than you would with a 401(k). This means you’re in charge of where your money is growing. Traditional IRAs are also more accessible. You can easily open one today if you have taxable income.  

What’s the difference between a Roth 401(k) and a Roth IRA?  

Contributions to both accounts are taxed upfront. The Roth IRA offers more flexibility regarding investment choices and additional transfer options, and you can even pass your distributions down to a person of your choosing.   

Traditional IRA Rules  

The 10% tax is still in place if you withdraw money from a traditional IRA before retirement. But you could avoid taxation if you meet one of the following requirements:  

  • You have unreimbursed medical expenses worth more than 7.5% of your AGI 
  • You’re totally and permanently disabled, or you have a terminal illness 
  • Your distributions aren’t more than the cost of your medical insurance (if you’ve had a period of unemployment)  
  • You’re the beneficiary of a deceased IRA owner  
  • Your distributions aren’t greater than your higher education expenses  
  • You use the distribution to buy, build, or rebuild your first home (up to $10,000)  
  • You’re receiving the distributions in the form of an annuity  
  • The distribution is due to an IRS levy  
  • The distribution is a qualified reservist distribution  
  • In the year you become a parent, you can withdraw up to $5,000  

As mentioned above, the annual contribution limit is $7,000 ($8,000 if age 50 or older). Your annual contribution to an IRA can’t exceed your earnings for that year. There is no minimum deposit required to open an IRA account, but sometimes brokers set minimum deposits. Check with the institution you’re opening the account with for more information.   

Contributions to your traditional IRA may qualify for a deduction. However, if you or your spouse are covered by a workplace retirement plan, your deduction will be reduced and phased out based on income thresholds.  

Filing Status 2024 Traditional IRA Income Phase-out Range 
Single $77,000 – $87,000 
Married filing jointly (spouse making contribution is covered by a workplace retirement plan) $123,000 – $143,000 
Married filing jointly (contributor is not covered by workplace retirement plan, but the spouse is covered) $230,000 – $240,000 
Married filing separately$0 – $10,000 

Roth IRA Rules  

There are phase-out ranges according to your income and filing status. If your income falls within or exceeds the ranges listed below, your Roth IRA contributions will be reduced or eliminated.   

Filing Status 2024 Roth IRA Income Phase-out Range 
Single or Head of Household $146,000 – $161,000 
Married filing jointly $230,000 – $240,000 
Married filing separately $0 – $10,000 

Since your Roth IRA contributions are made with after-tax dollars, you can withdraw at any age without penalty or additional taxation if you meet the below-mentioned requirements.  

  • You’ve had the IRA account for at least five years  
  • One of the following must be true: 
  • You are permanently and totally disabled  
  • You used the money to make a first-time home purchase  
  • Your heirs received the money after your death  

If you pass away before your account ownership meets the five-year mark, the IRS will tax your beneficiaries on the distributions until the five-year requirement is met. Regardless of age, your withdrawals will be taxed if you don’t meet the five-year test.  

Additionally, each traditional IRA you convert to a Roth IRA has its own five-year waiting period required to avoid an early withdrawal penalty.  

Spousal IRAs  

If you are employed, and your spouse isn’t, or they do not bring in enough income to contribute to an IRA, you can contribute to an IRA on their behalf. 

Learn more: How to Make Spousal IRA Contributions for Retirement 

Is a 401(k) or IRA better?  

Each one has its own perks, and the answer is very dependent on your personal circumstances. If you’re nearing retirement age or want to meet your retirement savings goals faster, an IRA might be a better option. On the other hand, if you’re just starting in the workforce, a 401(k) plan may suit you better.   

Can’t decide? You don’t have to choose just one retirement savings plan. You can invest in both plans and adjust as your life circumstances change.   

This article is intended to provide general information to the public and does not provide personalized tax, investment, legal, or business advice. You should seek the assistance of a professional for advice on taxes, investments, and any other financial, legal, or business matter pertinent to your individual situation.

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