The three main types of Retirement Accounts are the 401k, Traditional IRA, and Roth IRA. If you are or ever were employed in a full time salaried job, there is a good chance you already have a 401k account. But what about IRA, or Individual Retirement Accounts? Let’s start off by seeing how similar these three accounts are.
Similarities
- All of them allow you to withdraw money penalty-free at 591/2 years old.
- If you withdraw earnings before 591/2, all of these accounts will incur a 10% penalty fee on your withdrawals.
- They all have contribution limits that are not affected by rollovers.
- They will all charge 6% in taxes for each year you exceed the contribution limits.
So what exactly is the difference? Is one better than the other? This is what we will aim to answer as you read on.
401k
A 401(k) plan is a company-sponsored retirement account that employees can contribute to with potential employer matches. For example, my employer matches my contributions up to 6%. The 403b has similar properties and the same limit as a 401k, however they are meant for tax-sheltered public schools and other organizations. The 457b is also similar to the 401k, except it is for local or state government and non-profit organizations.
| Advantages | Disadvantages |
|---|---|
| Easy Payroll Deductions | You will owe taxes on gains |
| Employer Contribution Matches | You may end up paying more in Taxes when you withdraw your funds. |
| $20,500 Contribution Limit as of 2022 | May Have High Administrative Fees |
| Tax-Deductible Contributions | Limited Investment Options |
| You can take it with you or rollover to another 401k when you switch employers. | Contributions follow a set schedule that you cannot change depending on the company. Limited ability to change contributions. |
Traditional IRA
Like a 401k, a Traditional IRA is a retirement investment account that allows you to contribute pre-tax income with tax-deferred growth. You don’t have to pay capital gains tax or dividend income tax until you make a withdrawal A.K.A. take a distribution.
| Advantages | Disadvantages |
|---|---|
| Your contributions are Tax-Deductible | May not be tax-deductible, or may be partially tax deductible if you have a 401k and make a certain amount of money. Source. |
| Can be converted to a Roth IRA. You can make non-tax-deductible contributions if you want to, but will need to keep track of them. | Can only contribute $6000 per year ($7000 if you are over 50), assuming you make more than $6000 per year. |
| You can contribute to the prior year of your IRA by the tax due date, April 15th if you want to lower your taxes. Note: 2021 Tax Due Date is April 18th, 2022. | You can no longer contribute after you reach 701/2 years old. |
| You have more investment options than a 401k. | Must take minimum required distributions once you reach 701/2 years old, otherwise you will be penalized up to 50% on your minimum required distributions. |
Roth IRA
Roth IRA’s are retirement investment accounts that allow you to contribute after-tax income, in which your retirement distributions will be tax free on both your contributions and earnings/growth.
| Advantages | Disadvantages |
|---|---|
| You can withdraw your contributions (not earnings) tax-free and penalty-free after holding a Roth IRA for at least 5 tax years. | Income limitations in contributing to a Roth IRA. $129,000 if single and $204,000 if married filing jointly. |
| Enjoy tax-free growth and withdrawals in retirement. | Not Tax-Deductible. |
| No contribution age limit. You can still contribute when you’re 80 if you are still working and making at least $6,000 per year. | Can only contribute $6000 per year ($7000 if you are over 50) |
| No minimum required distributions when you retire. You can choose to keep your money in a Roth IRA for as long as you are alive without paying any fees. | |
| You can pass your ROTH IRA down to your children. Beneficiaries of Roth IRA’s won’t owe any taxes on their distributions. |
Managing Your Wealth
There are hundreds of ways you can manage your wealth. You can download one of my spreadsheets to help you track your net worth, your contributions, and budgets or you can join one of the following wealth management companies and open up a Roth or Traditional IRA. Both Betterment and Wealthfront are low fee robo-financial advisors that specialize in long term investing with automated retirement accounts. Sign up through my Betterment referral link or my wife’s Wealthfront link below and receive $5000 free management for a year. If you’d like your customize your Roth IRA contributions and invest in individual stocks, try M1 Finance and get $50 when you deposit your first $100 in 30 days.
In Conclusion
Which one you choose depends on your situation. If you have a good employer match, focus on your contributing at least the match towards your 401k. A Roth IRA is better if you assume that taxes will be higher in the future. A 401k or Traditional IRA are better if you think taxes might be lower in the future. In other words, do you plan on growing your career and making more money as you get older? If you answered yes, a Roth IRA is likely the better fit.
To minimize the uncertainty of taxes, I have both a 401k and Roth IRA account. If taxes are much higher in the future, we have the Roth IRA to fall back on. It may also be beneficial for you to have two, or all three of these retirement accounts. Keep in mind that the limit of an IRA is shared between the Roth and Traditional IRA. If you contribute $3000 to each, you will have reached the overall $6,000 IRA limit. The Mega Backdoor Roth Conversion is a trick I use to contribute more than the Roth IRA limit, but the government is trying to get rid of that loophole in 2023.
In my opinion, a Roth IRA is the best option if you are young. Historical data has shown that a Roth IRA will yield more money especially if you start early. The government allows you to withdraw your Roth IRA contributions after 5 years. That means you can use your Roth IRA for an emergency expense such as the cost of a surgery that is not covered by your health insurance. Subscribe below and stay up to date on your personal finance.
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