A 401(k) and IRA are both tax-advantaged retirement accounts, but 401(k)s are offered by employers (who often match employee contributions), whereas IRAs can be opened by individuals with any brokerage firm. Additionally, 401(k)s allow greater contributions but fewer investment options, whereas IRAs have more restrictive contribution limits -- sometimes even income caps -- but offer the opportunity to invest in virtually any stocks, bonds, or mutual funds.

Before saving for your later years, it's important to understand the key differences between IRAs and 401(k)s so you know where to put your investment dollars.

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401(k) vs. IRA

If you're debating between a 401(k) or IRA, the first thing to know is that you don't have to choose. You can invest in both.

However, traditional IRAs have income limits if the account holder or their spouse are also covered by a workplace retirement plan, such as a 401(k).

Some of the key differences between IRAs and 401(k)s include:

  • Employer vs. individual accounts: Most 401(k)s are offered through employers, while anyone can open an IRA with any brokerage so people don't have to depend on their company to offer one.
  • Contribution limits: While limits change annually, the contribution limit for 401(k)s is around three times higher than for IRAs. 
  • Eligibility rules: There are no upper income limits for 401(k) contributions, but high earners become ineligible to make deductible contributions to a traditional IRA or to invest in a Roth IRA at all.
  • Investment options: IRAs opened with major brokers offer a far wider selection of investment options, while most 401(k)s restrict you to 20 or fewer investment choices (usually mutual funds). 
  • Withdrawal rules: Early withdrawal penalties generally apply to both 401(k)s and IRAs if you take out money before age 59 1/2. However, there are different exemptions to these penalties with each type of account. And many workplace 401(k)s offer the opportunity to borrow against retirement funds, while IRAs don't. 

Let's take a closer look at some of these rules.

Contribution Limits

A 401(k) has a significantly higher maximum contribution level than an IRA. For 2020, the maximum contribution limits are:

Limits

IRA

401k

Basic limit $6,000 $19,500
Catch-up contribution limit for those aged 50 and older $1,000 $6,500
Total limit for those aged 50 and older $7,000 $26,000

Data source: IRS.

Remember, though, that eligibility for deductible contributions to a traditional IRA phases out for high earners if either they or their spouse has access to a workplace retirement plan. Higher earners also cannot make Roth IRA contributions at all. 

It's also important to note that contribution limits for a 401(k) only apply to employee contributions (remember a major benefit of 401(k)s is that employers often contribute, too). If you contribute $14,000 and your employer matches up to $6,000, that's a total yearly contribution of $20,000 -- but only your $14,000 counts toward the contribution limit; you could still contribute $5,500 more.

In 2020, total annual contributions to a 401(k), including employer additions, can go as high as $57,000 for most workers, or $63,500 for those over 50. The table below summarizes maximum total contributions. 

Plan type

IRA

401(k)

Maximum combined contribution for employee and employer

N/A

$57,000

Maximum combined contribution for employee and employer for those aged 50 and older

N/A

$63,500

Source: IRS.

For those who have the option of investing in a 401(k) and/or an IRA, employer matching can significantly tilt the advantage toward investing with a 401(k). If your employer matches all contributions, that's equivalent to a 100% return on investment. Over time, those contributions compound, leading to far more growth.

Unfortunately, when you leave your job, you are no longer allowed to contribute to your past employer's 401(k). Instead, you must make a choice between keeping your account with that company or rolling it over to an IRA or to your new employer's 401(k). 

Withdrawal rules

Both 401(k) and IRA plans are intended to help you save for your later years, so there are consequences of taking money out early. In general, if you take money out of either a 401(k) or IRA before age 59 1/2, a 10% early withdrawal penalty applies. However, there are some important differences in the rules for IRA vs. 401(k) withdrawals. 

First and foremost, it's possible to take a loan from a 401(k) but not from an IRA. Borrowing against your retirement account has significant downsides, but it does enable you to tap these funds without incurring an early withdrawal penalty.  

On the other hand, there are more options for early withdrawals from an IRA without incurring the 10% penalty than from 401(k)s. For example, the table below shows when you can take a penalty-free withdrawal from each type of account

Reason for Withdrawal 401(k) IRA
Total and permanent disability Yes Yes
Covering qualified higher educational expenses No Yes
Purchasing a home for the first time (up to $10,000) No Yes
Incurring unreimbursed medical expenses exceeding 10% of income Yes Yes
Paying health insurance premiums while unemployed No Yes
Military reservist called to active duty Yes Yes
Separating from your job in or after the calendar year you turn 55 Yes No

Table source: IRS

If you think you may leave your job in your mid-50s and want to take advantage of the Rule of 55, a 401(k) will offer the flexibility you're looking for. But if you want to be able to make a withdrawal to cover educational expenses, insurance premiums if you lose your job, or part of a home purchase, only an IRA will provide that option. 

Cost

As many as 95% of workers pay 401(k) fees, according to a survey conducted by TD Ameritrade and FeeX. The average fee is .45%; however, fees can vary substantially from one account to the next. 

Because 401(k) plans offer limited investment options, you may also find yourself restricted to mutual funds, which often charge higher investment fees than other investments accessible in an IRA. 

By contrast, IRAs typically come with few or no fees. Most brokers do not charge you to open an account and have eliminated commissions on trades. You can compare IRA providers to find ones that won't impose fees. Plus, with a broader choice of investments, you may also save by choosing lower-cost ETFs in your IRA. 

Flexibility

Most 401(k) plans offer very limited investment options, with the average 401(k) plan offering only 20 funds, according to Brightscope. Some 401(k)s now come with the option of a self-directed account -- meaning you can invest as you do with a normal brokerage account -- but this is not the norm.

An IRA is more like a normal brokerage account, so your investment options are almost endless.

If flexibility is most important to you, an IRA wins hands down. However, some investors prefer the simplicity of having only a few funds to choose from in a 401(k).

Ultimately, as you compare all of the differences between an IRA and 401(k), you may decide you prefer one over the other or you may opt for both. Either way, the important thing is that you're saving for your later years and building a diversified portfolio of sound investments that will provide for you after you've left the working world.