Updated: May 20, 2021
If you have ever thought about choosing a retirement plan, chances are you have heard at least one, or even all three of these terms: Traditional IRA, Roth IRA, and 401K. This likely has caused many questions to enter your mind, and we are here to answer them.
It’s important to sort out the differences between them. After all, this is your retirement we are talking about! Taking the right steps can make a big difference in your future.
What Is An IRA?
IRA stands for Individual Retirement Account. IRAs are essentially vehicles designed to help individuals save and invest for their eventual retirement from the workforce. The two most common types of IRAs have been designed for individual use meaning that individuals use them without any assistance from their workplace.
The traditional IRA is older than the Roth IRA. The traditional IRA first became available in 1975 and the Roth IRA was introduced in 1997 after being sponsored by U.S. Senator William Roth. Naturally, it was named after him to differentiate it from other IRAs like the traditional IRA.
Roth IRA vs. Traditional IRA
The traditional IRA and the Roth IRA both include provisions that enable tax-free growth of investments, but they also have differences. They mostly differ in how they deal with tax deductions. In other words, how and at what time your money is taxed.
Traditional IRA: Contributions made may be tax deductible depending on your income level, but withdrawals in retirement are taxable.
Roth IRA: Contributions to Roth IRAs are taxable, but withdrawals in retirement are tax free. However, keep in mind that your eligibility to contribute to a Roth IRA is based on your income level.
How To Choose The Right Type Of IRA?
With this knowledge, choosing the right IRA becomes a matter of when you feel you will have a higher tax rate.
A. Higher Future Tax Rate
If you predict that you will have a higher tax rate in retirement, choose the Roth IRA since withdrawals are tax free in retirement.
B. Lower Future Tax Rate
If you predict that your tax rate now is likely higher than it will be in retirement, you will want to be taxed later on while you are retired, so you should choose the traditional IRA.
This is assuming that your income is at a level that enables you and makes you eligible to contribute to a Roth IRA. Your income also determines how much of your contribution to a traditional IRA you can deduct from your taxes this year.
Deductions from traditional IRAs are restricted specifically if you or someone you are married to has access to a savings plan like a 401(k) through your workplace.
Advantages of a Roth IRA
For most people, going with a traditional IRA provides one main advantage: the access to a tax break now rather than later. However that way of thinking can be considered rather short sighted.
For those who qualify, there are definite advantages (more than one) to using a Roth IRA over a traditional one that you should consider when making your decision.
Early Withdrawal: In the event that you have to withdraw money from your Roth IRA you are allowed to withdraw money that you contributed to it at any time without paying income taxes or any penalty fees for withdrawing early.
Unfortunately, if you use a traditional IRA, you won’t be as lucky when withdrawing early. You will very likely have to pay a 10% fee for early withdrawal and owe taxes!
Multiple Retirement Accounts
Another advantage of the Roth IRA is that you can diversify your taxes by funding a Roth IRA while also using a 401(k) through your workplace. Having two retirement accounts will provide you with additional options later in life!
Finally, a Roth IRA allows you to leave your money untouched for as long as you like. With a traditional IRA, you are required to make withdrawals called "required minimum distributions" after you turn 72 years old.
For information on contribution limits, deadlines, and other frequently asked questions regarding traditional and Roth IRAs, it’s best to go directly to the source (meaning the IRS).
What is a 401K?
A 401(k) is a retirement plan that is sponsored by your employer. Employees are given the option to sign up for a 401(k) plan when they are hired. Some employers will match employee 401(k) contributions up to a certain amount, which is one of the benefits of saving with a 401(k).
Benefits Of A 401K
Some of the benefits of a 401(k) are that employers will often match contributions, they have a high annual contribution limit, contributions lower your taxable income for the year that they are made, and there is no income requirement in order to be considered eligible.
Limitations Of A 401K
Plan Control: One disadvantage of a 401(k) is that because plans are picked by your employer, you have no control over the plan and the costs of investing in it.
Ordinary Income Tax: Other disadvantages are that distributions in retirement are taxed as ordinary income (unless it is a Roth 401(k)), and like traditional IRAs, a 401(k) has “required minimum distributions” starting at age 72.
Although 401(k)s have a few disadvantages, if a company offers a 401(k) option with matching contributions it is generally considered a great employment benefit.
When an employee signs up for a 401(k), money is then automatically deducted from their paycheck.
Do you have a 401(k) as part of your employment package? If you do and you are curious about estimating what your 401(k) balance will be when you retire, try using a 401(k) calculator.
For more information on 401(k) plans and their regulations you can read this helpful information from the IRS.
Saving for Retirement
Saving for retirement is always a good idea, and these programs were developed by the government to encourage more people to save and think long-term.
Nobody wants to reach the end of their career with no money saved. If you are eligible for at least one of these retirement plans, we suggest that you use it. You certainly won’t regret it when you retire!
We recently announced our launch of IRA’s with All Of Us. Now, you can save for retirement and put your money on a mission with All Of Us. Start investing in your future with All Of Us, the radically transparent brokerage.
This should not be construed as legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.