The older women sit on a couch and look at a smart phone that one woman holds in her hand.

The 401(k) and the Individual Retirement Account (IRA) are two of the most prominent retirement savings accounts in the US. They are useful and play critical roles in planning to pay for your senior care needs during retirement. But, many people don’t know the difference between the two and which type of account makes more sense for them. To help point you in the right direction, here we compare and contrast these two retirement accounts.

What is a 401(k)?

A 401(k) plan is a retirement savings account your employer may offer. While not every employer will offer employees a 401(k) plan, those who do will typically have an “employer match” program. Employers with match programs will contribute additional money to your 401(k) when you make contributions. For instance, an employer may offer a 100% match of all contributions up to 3% of your salary. But, it’s important to note that terms will vary from employer to employer.  

401(k) plans also come with tax advantages. A Traditional 401(k) plan allows employees to contribute pre-tax income and benefit from tax-deferred growth on their savings. A Roth 401(k) allows employees to contribute post-tax income and enjoy tax-free growth.  

What is an IRA?

An Individual Retirement Account allows anyone to save for retirement in a tax-advantaged account. As the name would suggest, individuals open and maintain IRAs, not employers. This means you can open an account at whatever bank you choose and invest in practically anything you would like.  

Much like the 401(k), there are two types of IRAs — the traditional IRA and the Roth IRA. Roth IRAs allow individuals to grow their wealth tax-free, whereas Traditional IRAs allow for tax-deferred growth.

Withdrawal differences between 401(k) plans and IRAs

At a certain point, you will want to distribute money from your 401k or IRA to yourself to pay for your senior living expenses. It’s critical to know the withdrawal rules, and that’s one area where both IRAs and 401(k) accounts are similar. Both types of accounts require you to be 59.5 years old to withdraw money without penalty. For early withdrawals in either an IRA or 401(k), you will be subject to a 10% penalty and any unpaid taxes.

Both types of accounts have exceptions that allow you to avoid this 10% penalty for early withdrawals. Some of these exceptions may be related to senior care expenses, but overall, they are very niche. It may be difficult to avoid paying the penalty if you need to make an early withdrawal.

Contribution differences between 401(k) plans and IRAs

One area where 401(k) plans and IRAs differ in a major way is contribution limits. 401(k) plans allow employees to contribute up to $20,500 (in 2022) per year to their accounts. Additionally, unlike the IRA, you are eligible to contribute to your 401(k), regardless of how much money you make. This makes the 401(k) a great choice for those who aren’t eligible to contribute to an IRA.

On the other hand, you may only contribute to an IRA if you make less than $144,000 as a single filer or $214,000 as a married couple filing jointly. This is a serious pain point for high-income earners. Those eligible to contribute to an IRA may contribute up to $6,000 (in 2022) per year. Contributors over the age of 50 may contribute an additional $1,000 per year to “catch up.” This is helpful when someone approaching retirement age wants to save as much money as possible to fund retirement and future senior living needs. 

When is it better to choose a 401(k)?

Ensuring you receive your full employer match in your 401(k) is often considered best practice. After all, if you’re not taking full advantage of your employer match program, you’re leaving free money on the table.

Once you’ve taken full advantage of your employer’s match program, deciding where to contribute your savings may be difficult. 401(k) plans and IRAs offer similar benefits, so the choice may come down to your income. For folks who make more money than the IRA income cap, the 401(k) is often their only choice for retirement savings.

When is it better to choose an IRA?

Unfortunately, the IRA may be the only option available for some people. In this case, you should contribute to an IRA, which will afford you more tax advantages than traditional savings/brokerage accounts. And, you’ll be able to plan for paying for senior care expenses that will come up as you age. If you have a 401(k) plan and you’ve already gotten your full employer match, contributing to your IRA may be a great choice.

Bottom line: Is a 401(k) or IRA better?

Knowing that the cost of senior care adds up over time, saving in either (or both) types of accounts may be a great idea. If you’re comfortable tying up your money until you turn 59.5, both accounts can provide incredible tax-advantaged growth for your retirement savings. 

As always, you should work with a financial advisor to determine how much money you should contribute to each of these accounts. Each person’s financial position is different, so having a financial plan tailored to your unique circumstances is critical.