IRA vs. 401(k): What’s Really Best for Your Retirement Money?

You’ve decided.

You’re ready to set aside money for retirement.

Kudos! That will soon put you ahead of nearly 41 million of your fellow Americans!

According to the Federal Reserve, only 36 percent of non-retired Americans felt they were on track for retirement (even those in their 60s, a small majority, 52 percent did not feel confident), while 26 percent had no retirement savings at all.

But what’s the best way to save for retirement?

What Options Do You Have for Your Retirement Investing?

As I’ve written elsewhere, the best retirement plan (if you qualify) is actually not a retirement plan at all. It’s the Health Savings Account (HSA). The HSA provides a triple tax benefit: (a) contributions reduce your taxable income in the year you contribute, (b) any gains in the plan are tax-free, and (c) any withdrawals used for qualified health-related expenses are tax-free (and how many retirees have you heard of who have no health-related expenses?).

However, not everyone qualifies for an HSA, and even if you do, 2022 contribution limits are just $3650 for individuals and $7300 for families, with a $1000 catchup provision for those over age 55. Thus, for the following, we’ll assume you need other options, instead or in addition.

So, whether you can’t use an HSA at all, or want to contribute more toward your retirement, two popular and widely available options are IRAs and 401(k) plans.

If you work for a governmental entity or nonprofit organization, you likely have access to a 403(b) plan, and possibly a 457 plan, but those are outside the scope of this article.

Which Is Best for Your Retirement Investments – IRAs or a 401(k)?

Unfortunately, there isn’t a simple and unequivocal answer to that question. Each of these has unique benefits and drawbacks compared to the other.

Danielle Miura, CFP^®, founder and owner of Spark Financials, says, “Before deciding, read your employer’s employee handbook to see if they offer a 401(k), and if so, do they offer to match your 401(k) contributions. If they do offer a match, grab it – it’s free money!

“Beyond that, the 401(k) offers several advantages over IRAs. If you’re uncomfortable picking investments for your retirement portfolio, the 401(k) may be better. If you’d like to (and can) put a large sum towards your retirement account each year – you can contribute three times more to a 401(k) than to an IRA.

“On the other hand, while a 401(k) is only available if your employer offers it, you can easily open an IRA online with any brokerage or mutual fund company.”

Blaine Thiederman MBA, CFP, agrees, “401(k) plans have the following benefits (in 2022) that IRAs don’t:

• “You can contribute up to $20,500 a year if you’re under 50 to a 401(k), and $25,500 if you’re over.
• “If you earn over $68,000 filing single or $109,000 filing jointly, you can deduct 401(k) contributions, but not IRA contributions.
• “If you’re involved in a lawsuit, not all states’ asset protection laws protect IRAs. However, 401(k) plans are protected by federal statute – ERISA. Even if you file for bankruptcy, sometimes your 401(k) assets is protected from liquidation.
• “If offered by your employer, you’d be smart to take advantage of any 401(k) contribution matching.

“While 401(k) plans have far fewer investment options than IRAs, that can be a very good thing. You’d be surprised by how many people I’ve worked with over the years whose IRAs were in cash rather than invested. Why? They say, ‘I didn’t know what to invest in!’ Usually, 401(k) plans have a default investment such as target-date funds. Even if those aren’t the ideal choice for you, at least they have you invested for growth. The overwhelming number of IRA investment choices may cause some DIY investors to make life-changing mistakes.”

A Summary Table of Pros and Cons

Here’s a quick reference table comparing 401(k) plans to IRAs (as of 2022).

	401(k)	Individual Retirement Account (IRA)
Contribution limit	$20,500	$6,000
Catch-up contribution over age 50	$6,500	$1,000
Employer match	If offered	None
Investment choices	Limited by specific plan	Extremely broad selection
Investment advice	Offered by over 40 percent of plans	None, unless your portfolio is high enough for the IRA provider to offer it, possibly free
Tax-deductible	Yes	Yes, however, if you or your spouse are covered by an employer retirement plan, your income must be under limit
Expenses	Plan-dependent; fund fees may be lower than the same funds outside the plan; but may have plan fees on top of fund fees	Investment-dependent
Taxes on withdrawals	Taxed as regular income (unless Roth)	Taxed as regular income (unless Roth)
Subject to RMDs	Yes, subject to RMDs (Required Minimum Distributions) unless still employed by that employer, and don’t own more than 5 percent of the employer	Yes
Protection against lawsuits and bankruptcies	Protected by ERISA and possibly by state statutes	Possibly protected by state statutes

And the Answer Is… Both, in Turns

As the above table demonstrates, both the 401(k) and the IRA have significant advantages. That being the case, the answer likely to be best for most people is to use both of them, each in turn.

Here’s how.

1. If your employer’s 401(k) offers a match, consider contributing enough to that plan each year to capture the most you can. It gives you an instant return of 50 or 100 percent, depending on the details of the match you’re working with.
2. Once you’ve captured as much of a match (if any), fund an IRA up to the annual limit that applies to you as long as you’re eligible for a tax deduction. This gives you more flexibility and more diversification along with the tax deduction. If you have free investment advice through the 401(k), see if the advisor will help you choose the best investments for your IRA too, to help avoid the overwhelm of too many choices.
3. If you’ve maxed out the IRA to the extent that it’s tax-deductible, go back to contributing to the 401(k), until you max out the contribution limit to benefit from the most tax deduction possible.
4. Then, if you still have investable money available and haven’t maxed out your IRA contribution, consider contributing to a Roth IRA (see more on those below), and if you aren’t eligible for that, consider non-tax-deductible contributions to your IRA. There, at least the annual returns aren’t taxable until you start withdrawing in retirement.

Is It Better to Contribute to Traditional or Roth Accounts?

Traditional 401(k) and IRAs are best when you expect to benefit more from a current tax deduction. Ian Weiner, CFP®, says, “The decision to contribute to a traditional 401(k) or IRA vs. a Roth option comes down to what your long-term tax assumptions are, which is likely different from one person to another.

“Traditional IRAs and 401(k) plans offer a tax deduction in the year of the contribution [possibly limited by your income in the case of the IRA – OG], with taxes deferred until withdrawal. If your income is higher than normal in a particular year due to a bonus or incentive compensation, it can make sense to contribute the maximum amount into a traditional 401(k) and/or IRA to reduce your taxes in the current year.

“It can also make sense to contribute to a traditional 401(k) or IRA if you plan to later convert it to a Roth. This is particularly common when someone is charitably inclined and plans to make a few large strategic donations in the same year as strategic Roth conversions, resulting in zero tax.

“Real estate investors who qualify for the Real Estate Professional passthrough rules can also use depreciation from real estate activities to ‘offset’ ordinary income derived from Roth conversions. This strategy, while viable, is complex and requires the coordination of professionals.

“The flip side is that when you finally make withdrawals, voluntary or RMDs, the distributions get taxed as ordinary income, at your highest marginal rate. Since this increases your taxable income for the year of the withdrawal, it could even cause Social Security to be taxable based on the ‘Provisional Income’ calculation. The promise of being in a lower tax bracket in retirement may not be realized by many due to these additional challenges.

“Contributing to a Roth 401(k) can be an excellent strategy to pay a known tax rate to get assets into long-term savings that grow tax free. Many people do this because of the uncertainty of future tax rates, effectively ‘locking in’ today’s taxes.

“If you want to contribute to a Roth account, but make too much to make Roth IRA contributions, Roth 401(k) plans offer a great solution. These plans share the higher limit of traditional 401(k) plans, and you can contribute to them no matter your income level.”

Danielle Miura agrees, “If you’re in a higher income tax bracket, check if you qualify to contribute to a Roth IRA. If not, Roth 401(k) plans have no income limits. However, unlike Roth IRAs, Roth 401(k) plans are subject to RMDs, so you’ll be required to start withdrawing from your account starting at age 72 [unless you’re still employed by that employer and don’t own over 5 percent of the employer – OG].”

The Bottom Line

Both IRAs and 401(k) plans offer great tax advantages. Each plan type has its own pros and cons, which apply differently to people’s different specific situations.

Overall, however, most would benefit most by first contributing to an HSA, if their health insurance is HSA-compatible. Then, contributing to their 401(k) plan (traditional or Roth) enough to capture the maximum employer match (if offered any). Then, contributing up to their tax-deductible limit to a traditional IRA. Then, going back to the 401(k) and contributing up to the maximum allowed there. Finally, contributing any remaining amount up to the IRA limit to a Roth IRA. The above provides more specifics.

Whether you’re nearing retirement or just starting out in your career, you may find it useful to hire a nearby financial advisor or a specialist financial advisor with the knowledge and experience to help guide you on a path to a comfortable retirement.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.