401(k)s vs. IRAs: What’s the Difference?

There are probably more types of 401(k)s and IRAs than you realize, but they have more similarities than you might expect. The biggest difference is, typically, 401(k)s are offered by employers to their employees while IRAs are offered by financial institutions to individuals.
 

Consider 401(k)s

 
If your employer offers a 401(k) plan, you can contribute a percentage of your annual salary to it. Most businesses will offer a contributing “match.” As an example, for every $1 you divert into your 401(k), your employer could contribute $0.50 — not a bad ROI — but not guaranteed, either, since all contributions are investments that can gain or lose value. 401(k)s enable a participant to make larger annual contributions than IRAs, but they usually have a more limited offering of investment options.
 
Some businesses will require you to contribute a minimum percentage in order to earn the employer match. Others may follow a vesting schedule, meaning you must meet specific years-of-service requirements before you own 100% of your account’s investments. For 2021, the annual amount an employee can contribute to any 401(k), other than a SIMPLE 401(k), is $19,500. Employees age 50 or more may contribute an additional $6,500 as a catch-up contribution.*
 
Optional withdrawals can be taken by an owner 50-1/2 or older and are taxes are paid at disbursement. Withdrawals taken earlier are subject to a 10% additional tax penalty.
 
You can take a penalty-free loan from your 401(k) account if you experience certain hardships, including: medical expenses, mental or physical disabilities, home expenses (first-time purchase, eviction/foreclosure prevention, or disaster repair), up to 12 months of higher education bills (for you, your spouse, your children, or your grandchildren), and more.
 
There are five main types of 401(k)s:
 

• Traditional — For businesses of any size. Traditional 401(k) account contributions are funded by pre-tax salary deferrals that are deposited into your 401(k) account. This reduces your annual taxable income. With traditional 401(k)s, after you reach the age of 72, you must take annual Required Minimum Distributions (RMDs). (If you were born before July 1, 1949, you are required to take annual RMDs starting at the age of 70-1/2 years old.) Depending on your business’s plan, you could be required to take RMDs the year you retire, regardless of your age. Because contributions were made with pre-tax dollars, taxes are paid on withdrawals at your current tax rate when the withdrawals are made.

 

• Roth — For businesses of any size. Contrary to traditional 401(k)s, Roth 401(k) contributions are made with after-tax dollars, so contributions are not tax-deductible.
  • Withdrawals are optional (no RMDs) — and tax-free as long as the account has been open at least five years. Roth 401(k)s and IRAs are named for the Republican senator from Delaware, William V. Roth, Jr., who sponsored the pay-now/tax-free-withdrawals-later products as part of the Tax Relief Act of 1997. Think of ROTH as Retire Off The Hook (because taxes have been pre-paid).

 

• SIMPLE (Savings Incentive Match Plan for Employees) — Similar to a traditional 401(k), but for small businesses with 100 or fewer employees. Employers are required to make plan contributions for employees that are immediately 100% vested.
  • Unlike the other 401(k) options, the annual amount an employee can contribute to a SIMPLE 401(k) for 2021 is $13,500. Employees age 50 or older may contribute an additional $3,000 as a catch-up contribution.

 

• One-Participant or Solo — This traditional 401(k) plan is for sole proprietorships (self-employed business owners and their spouses, with no employees). With these 401(k)s, the owner can contribute as a traditional plan employee and up to 25% of his or her compensation as employer, not to exceed a combined total of $58,000 as of 2021.

 

• Safe Harbor — Similar to a traditional 401(k) but for businesses of any size. However, employers are required to make plan contributions for employees that are immediately 100% vested.

 

	Compare 401(k)s in 2021
	Traditional	Roth	Safe Harbor	SIMPLE	Solo
Business Size	Any	Any	Any	≤ 100 employees	Sole proprietor
Contributors	Employer (optional) and employee	Employer (optional) and employee	Employer and employee	Employer and employee	Optional employer and/or employee
Annual Contribution Maximums*	$19,500 (+ $6,500, if age 50 or older)	$19,500 (+ $6,500, if age 50 or older)	$19,500 (+ $6,500, if age 50 or older)	$13,500 (+ $3,000, if age 50 or older)	$19,500 (+ $6,500, if age 50 or older) as employee and < $58,000 combined with employer match
Contribution Dollars	Pre-tax	After-tax	Pre-tax	Pre-tax	Pre-tax
Vested Schedule	Determined by business	Determined by business	Mandatory employer contributions are  immediately vested	Mandatory employer contributions are  immediately vested	Immediately vested 100%
RMDs	Yes	No	Yes	Yes	Yes
Taxed Disbursement	Yes	No	Yes	Yes	Yes

 
 

Weigh IRA options

 
An IRA (Individual Retirement Arrangement, an account or an annuity) enables you to contribute to a wider variety of investment options than 401(k)s, such as: CDs/share certificates, share savings, mutual funds, or individual stock and bonds. The allowable maximum contribution amounts, however, are smaller. IRAs are owned by individuals, so there are no company match opportunities (except with SIMPLE IRAs). Even if you participate in a retirement savings plan at work, you probably qualify to contribute to a traditional or Roth IRA as well. However, doing so may reduce your traditional IRA deductions.
 
For 2021, the annual amount you can contribute to a traditional or Roth IRA is $6,000. Investors age 50 or older may contribute an additional $1,000 as a catch-up contribution.*
 
Like 401(k)s, optional withdrawals can be taken after the age of 50-1/2 and taxes are paid at disbursement. Withdrawals taken earlier are subject to a 10% additional tax penalty.
 
There are four main types of IRAs:
 

• Traditional — As with traditional 401(k)s, you deposit pre-tax money, reducing your taxable income.
  • Annual contributions are entirely optional. You can contribute one lump sum, nothing, or some plans allow multiple deposits throughout the year.
  • Annual withdrawals or RMDs are required to be taken after you reach age 72. (If you were born before July 1, 1949, you are required to take RMDs starting at the age of 70-1/2 years old.) Because contributions were made with pre-tax dollars, taxes are paid at disbursement.

 

• Roth — Contrary to traditional IRAs, but similar to Roth 401(k)s, contributions to these plans are made with after-tax dollars, so they are not tax-deductible. Withdrawals are optional (no RMDs) — and tax-free as long as the account has been open at least five years.

 

• SIMPLE (Savings Incentive Match Plan for Employees) — Similar to a traditional IRA and for small businesses with 100 or fewer employees. The annual amount an employee can contribute for 2021 is $13,500. Employees 50 or older may contribute an additional $3,000 as a catch-up contribution. Employers have two contribution options: They can contribute 2% of an employee’s salary or match the employee’s contributions dollar-for-dollar, not to exceed 3% of the employee’s salary.

 

• SEP (Simplified Employee Pension) — Similar to a traditional IRA with pre-tax dollars being invested, it is for businesses of any size. Only an employer can contribute to a SEP; no employee contributions are made. SEPs are easier to set-up and administer than a 401(k), so they provide businesses with another way to offer employees retirement savings.

 
The contribution maximums are much higher than the maximums of other IRA plans. Employers can contribute up to 25% of an employee’s salary, not to exceed $58,000 or $64,500 for employees age 50 or older. Contribution amounts may vary from year to year.
 
 

	Compare IRAs in 2021
	Traditional	Roth	SEP	SIMPLE
Business Size	—	–	Any	≤ 100 employees
Nondiscrimination Tests Required	No	No	No	No
Contributors	Individual	Individual	Employer only	Employer (optional) and employee
Annual Contribution Maximums*	$6,000 (+ $1,000, if age 50 or older)	$6,000 (+ $1,000, if age 50 or older)	Up to 25% of an employee’s salary, not to exceed $58,000 or $64,000 for employees age 50 or older)	$13,500 (+ $3,000, if age 50 or older)
Contribution Dollars	Pre-tax	After-tax	Pre-tax	Pre-tax
Vested Schedule	—	—	Mandatory employer contributions are immediately vested	Immediately vested 100%
RMDs	Yes	No	Yes	Yes
Taxed Disbursement	Yes	No	Yes	Yes

 
 

Additional notes about RMDs

 
Your RMD amount will vary depending on your account balance and your age. While the IRS has plenty of forms, fortunately their RMD Worksheet happens to be a very simple one — just three easy steps and one chart. If your spouse is the sole beneficiary of your account AND more than 10 years younger than you, use this RMD Worksheet instead. Note that the first step has not been updated to account for the adjusted age 72 rule.
 
TAKE YOUR RMDs. If you don’t, you’ll owe the IRS an additional tax equal to 50% of the RMD amount! If you’re fortunate enough that you don’t need to spend your disbursement right away, here are some suggestions about how to best use your withdrawals.
 

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* Depending on your tax filing status and your Modified Adjusted Gross Income (MAGI), maximum contribution amounts may be reduced.