What you will learn in this article:
An IRA or Individual Retirement Account and a 401(k) are both investment vehicles that allow you to save for retirement with tax advantages. The main difference between the two is that a 401(k) is sponsored by your employer, while an IRA is an individual plan. Both IRAs and 401(k)s come in two flavors: Roth and Traditional. The primary difference between these two options is how they are taxed. I have broken down the key differences in this article to help you determine which is the right fit for your goals.
You can only take money out of a retirement account after the age of 59 ½ otherwise you have to pay a 10% early withdrawal penalty which is never recommended. There are exceptions to the early withdrawal penalty, such as a first-time home purchase, or higher education expenses. For a more detailed explanation on if you should take an early withdrawal read our article here.
The Difference between a Roth and Traditional:
The key difference is that a Roth IRA or 401(k) is funded with after-tax dollars, meaning that no taxes are due on the contributions or earnings when they are withdrawn during retirement. A Traditional IRA or 401(k), on the other hand, is funded with pre-tax dollars, and withdrawals in retirement will be taxed as income.
When to Invest in a Roth or Traditional IRA/401(k):
When deciding which option to invest in, it depends on your current income, future income, and when you expect to retire. A Roth IRA may be a good option for those who expect to be in a higher tax bracket in retirement than they are now, as they will not have to pay taxes on withdrawals. A Traditional IRA may be a better option for those who expect to be in a lower tax bracket in retirement than they are now, or for those who want to reduce their current tax liability.
How to Start Investing in a Retirement Plan:
Regardless of which option you choose, the most important thing is to start saving for retirement as early as possible. One easy way to get started is to participate in a 401k plan offered through your employer. Many employers offer matching contributions, which can be a great way to boost your savings. Additionally, you can open an IRA at a brokerage firm or bank. Below is a table for helping you decide which would be the best option for you:
Table of Differences:
​Feature | Roth | Traditional |
How are Contributions Taxed? | Contributions are made with after-tax dollars. | Contributions are made with pre-tax dollars. In the case of IRA's they are "tax-deferred" which is essentially the same thing. |
Taxation of Withdrawals | Withdrawals are tax-free if the account has been open for at least five years and the individual is 59.5 or older. | Withdrawals are taxed as ordinary income in retirement. |
Required Minimum Distributions (RMDs) | RMDs are not required during the account holder's lifetime. | RMDs must begin at age 72. This means you must start taking out from your retirement plan at this age. |
Contribution Limits | IRA: For 2023, individuals under age 50 can contribute up to $6,500 per year, while those 50 and older can contribute up to $7,500. 401 (k): for 2023 the contribution limit for a 401 (k) plan is $22,500. If If you are over the age of 50, you have the opportunity to make additional contributions of $7,500 through catch-up contributions, bringing your employee contribution limit to $30,000 for that year. | Same as Roth. |
Eligibility | If you file taxes as a single person, your Modified Adjusted Gross Income (MAGI) must be under $144,000 for tax year 2022 and $153,000 for tax year 2023 to contribute to a Roth IRA, and if you're married and file jointly, your MAGI must be under $214,000 for tax year 2022 and $228,000 for tax year 2023. 401(k)s have no limit. | There are no income limits for tax-deductible contributions to a traditional IRA or 401(k)s. There are some limitations on tax deductions, however. |
Recommended for | Young people, high-income earners, those expecting tax rates to be higher in retirement, and those who prefer tax-free withdrawals in retirement. I generally recommend Roth for most people in most situations if they are younger, generally under age 40. This is because the growth can be significant over a long period of time. Outgrowing the tax savings that you would save at a lower rate. | People who may be in a lower tax bracket in retirement, people who expect to have lower income in retirement, and people looking for tax-advantaged ways to save for retirement. Traditional is also a great option and allows you to lower your taxes and push your taxes into a lower range. However, the distributions are taxed as income in retirement, and for younger people that can be significant. |
Conclusion:
In conclusion, Roth and Traditional IRAs and 401ks have important tax differences that should be taken into consideration when choosing between them. Your current and future income levels, as well as your expected retirement age, will play a role in determining which option is best for you. The most crucial step is to start saving for retirement as soon as possible, so you can have a comfortable retirement.
I (David) personally expect to continue growing my wealth into retirement making the Roth option the best option for me as I expect my income in retirement to be higher than my income while working. I also love the idea of having a tax-free account appreciating that I can pull from in retirement. Whichever you decide, you should prioritize investing for retirement no matter what.
Glossary of Terms:
IRA (Individual Retirement Account): A tax-advantaged savings account for individuals to save for retirement.
401(k): A retirement savings plan offered by an employer that allows employees to contribute pre-tax dollars (Traditional) or post-tax (Roth) and potentially receive matching contributions from the employer.
RMD (Required Minimum Distribution): A minimum amount that must be withdrawn from certain types of retirement accounts, such as traditional IRAs and 401(k)s, starting at age 72.
MAGI (Modified Adjusted Gross Income): An individual's adjusted gross income (AGI) after taking into account certain allowable deductions and tax penalties.