When it comes to saving for retirement, there are two main options: an IRA and a 401(k). Both offer tax advantages when you invest, but there are differences. Below, we’ll explain exactly how each of these accounts work so you can figure out what works best for you. 

IRA

What is it?

An IRA (individual retirement arrangement) is a tax-advantaged retirement account you open for yourself as an individual. There are two types of IRAs: traditional and Roth. 

A traditional IRA lets you make tax-deductible contributions and your money grows on a tax-deferred basis, which means your money is taxed when you withdraw it from the account.

With a Roth IRA, your withdrawals are tax-free if you follow certain rules. The account is funded with post-tax dollars and you can’t deduct your contributions for tax purposes. 

Pros:

  • Flexible investment options. You can choose your brokerage and types of investments you make.
  • You have until tax day to fund your IRA for the year. 
  • With a traditional IRA, contributions reduce your taxable income for the year. You’ll see the tax benefit now versus during retirement. 
  • With a Roth IRA, withdrawals in retirement are tax-free.  You’ll see the tax benefit in retirement versus right now.

Cons:

  • There are yearly contribution limits ($6,000/year in 2022 if you are under 50) and you can only contribute your earned income for the year.
  • Contribution limits are lower than a 401(k).

The bottom line: IRAs are great options if your employer doesn’t offer a 401(k) match and you’re looking for investment flexibility. 

401(k)

What is it?

A 401(k) is a retirement savings plan that an employer sets up on an employee’s behalf. There are tax advantages for saving for a 401(k), just like an IRA. 

If your employer offers to match your contributions, it’s best to fund a 401(k) over an IRA so you can take advantage of that benefit.

Pros:

  • Your employer may match your contributions.
  • Higher annual contribution limit ($20,500 for 2022 if you are under 50).
  • Contributions reduce your taxable income for the year. 

Cons:

  • Limited investment selection and no control over your plan or costs.
  • Distributions are taxed as income in retirement unless you have a Roth 401(k).

The bottom line: If your employer offers a 401(k) match, take advantage of it and fund it over an IRA. Once you get the full company match, you can fund an IRA with any remaining funds