Is a 401(k) an IRA?

When it comes to saving for retirement, you’ve probably heard people throwing out terms like 401(k) and IRA, and maybe even using them interchangeably. You may also know that both a 401(k) and an IRA are retirement accounts. But is a 401(k) an IRA? Simply put, no. While both allow you to take advantage of similar tax benefits, they aren’t one in the same.

Here’s a brief rundown of both 401(k)s and IRAs.

WHAT IS A 401(K)?

A 401(k) is a retirement plan that is offered to you through work. Contributions are taken directly out of your paycheck, and often companies will match what you contribute up to a certain amount. If you have a traditional 401(k), you won’t owe tax on your contributions or on the money as it grows, but you will pay income taxes when you take the money out in retirement.

Because 401(k)s are offered through your employer, you will be required to use the investment options available within your employer’s plan. Depending on what's available to you, you may have myriad options or only a handful of choices in which to invest your contributions. Your options will typically include a range of investments with different levels of risk.

Generally, lower risk investment options offer more safety but less growth potential, while higher risk options offer more growth potential but are more volatile. Many plans also offer target-date funds, which can be a more hands-off way to manage your investments. These funds adjust your investments and risk over time based on your target retirement date.

While there are ways to use funds in your 401(k) prior to retirement, you typically won’t be able to access them without paying penalties and fees until you reach age 59 ½. After that, you can begin to take distributions from your 401(k) without owing penalties. You will, however, owe tax when you withdraw your funds. And once you turn 72, you must take required minimum distributions (RMDs).

Because of its tax advantages, there is a limit to the amount you can contribute to a 401(k) each year. In 2021, the limit is $19,500. Once you turn 50, you can contribute an additional $6,500.

WHAT IS A ROTH 401(K)?

If your employer offers it, you can take advantage of a Roth 401(k). Most of the rules are the same as a traditional 401(k), and if you choose to contribute to both, the yearly contribution limits apply to the combination of your Roth and traditional 401(k) contributions. The key difference is how your funds are taxed. With Roth contributions, your money is taxed before it goes in. But then it grows tax-free and typically will not be taxed when you take distributions in retirement.

WHAT IS AN IRA?

An IRA stands for Individual Retirement Account or Individual Retirement Arrangement. It works similarly to a traditional 401(k), but it’s available to anyone — you don’t need to go through an employer to open an account. An IRA also typically offers more investment options. You can even put money into an annuity in an IRA. The key difference between a 401(k) and an IRA is the yearly contribution limit. IRA contributions are capped at $6,000 each year; $7,000 if you’re 50 or older. If you contribute to a 401(k) at work, there may be limits to how much you can contribute to an IRA.

WHAT IS A ROTH IRA?

There is also a Roth version of an IRA. As with the Roth 401(k), your money is taxed before it goes in, but then typically never again. Roth IRAs also have the same contribution limits as their traditional counterparts — but as your income grows, the amount you can contribute decreases. If you make $140,000 or more as a single filer or $208,000 or more married filing jointly, you can no longer contribute directly to a Roth IRA (as of 2021). When you get to retirement, a Roth IRA doesn’t require RMDs during your life (Roth 401(k)s do have RMDs).

TAX-ADVANTAGED RETIREMENT SAVINGS

While a 401(k) and an IRA are technically different, they both help you maximize your retirement savings through their tax advantages. When saving for retirement, it can be helpful to use a mix of traditional and Roth accounts to help diversify your savings from a tax perspective. Doing so will give you more flexibility in retirement to help minimize the taxes you’ll owe each year, making each dollar you save go a little farther. A financial advisor can help look at your retirement savings options and show you how your savings can translate into income in retirement.