After years of commuting to a place of employment or running their own business, many people dream of a life of leisure when they reach a certain age and retire. But unless you inherit a large sum of money, you are going to need to plan ahead to make those dreams come true.

The best way to save for your golden years is through a retirement savings account.

Depending on where you work, you have a few choices. If you work for an employer, they may sponsor a 401(k) plan with company matches.

In addition, you can contribute to an IRA—either a traditional IRA or a Roth IRA. If you are self-employed, IRAs are your preferred choice.

While all three of these options serve the same purpose of saving for the future, they all go about it slightly differently.

So, Roth IRA vs Traditional IRA vs 401k; let’s explore how each of these plans works and the advantages and disadvantages of each plan.

Retirement Savings Accounts and Plans

We will talk about the three retirement plans that those who work for a private employer or themselves might invest in—a 401(k), a Roth IRA, and a traditional IRA. If you work for a government employer, you will have different choices.

Roth IRA VS Traditional IRA: What’s the Difference?

IRA means Individual Retirement Account. There are two different types—traditional plans and Roth IRAs. There are contribution limits for any IRA and income limits for the Roth, but the biggest difference is when you are taxed. 

A traditional IRA behaves in much the same way as an employer-sponsored 401(k) plan. You can contribute to your IRA plan before paying taxes to reap certain tax benefits.

When you earn income, you take out the contributions, and then you are taxed on the remaining income. Once you reach retirement age and start withdrawing money, you then pay taxes on the amount you withdraw. 

With the Roth IRA, you pay your income taxes and then fund the Roth with the after-tax funds. Once you reach retirement age, you can withdraw your investment and its proceeds tax-free.

There are a couple of conditions—you must be 59 ½ years old before withdrawing any money and have held the contribution in the account for at least five years.

You, not your employer, hold both IRA accounts. You decide how and where to invest the funds.

What is a Roth IRA?

The Roth IRA was established in 1997 as part of the Taxpayer Relief Act. You can fund it with after-tax dollars, invest the funds in your choice of securities, and withdraw your funds tax-free when you retire.

There are contribution and income limits, a minimum withdrawal age, and a minimum length of time money must stay in the funds.

Roth IRA Contribution Limits

Contribution limits to any IRA vary from year to year. You can have several IRA accounts, but, the yearly contribution limits are for all IRA accounts combined.

For 2023, the contribution limit for investors under the age of 50 is $6,500 per year.

If you are age 50 or older, you may contribute $7,500 per year. You may contribute to any IRA as long as you make an income greater than your contribution.

Roth IRA Income Limits

Only those below a certain income limit can make Roth IRA contributions. There are partial contributions allowed between specific income ranges as well.

For 2023, if you are filing as a single person, you can contribute the full amount if your annual income is less than $138,000. If your annual income is between $138,000 and $153,000, you can contribute a lesser amount determined by the IRS. If you earn over $153,000, you cannot contribute to a Roth IRA.

For 2023, if your tax filing status is married, filing jointly, the limit is based on your and your spouse’s combined income. You may contribute the maximum amount if your income is less than $218,000.

If your income is between $218,000 and $228,000, you may contribute a partial amount determined by the IRS. If your income is over $228,000, you cannot directly contribute to a Roth IRA.

If you earn over the higher thresholds, you may contribute to a traditional IRA and roll it into a Roth. This is called a backdoor Roth, and there are some special rules that you should discuss with a financial advisor.

Roth IRA Withdrawals

As previously mentioned, Roth IRA contributions are made with dollars that have already been taxed. Upon reaching age 59 ½, you may start withdrawing your contributions and your proceeds tax-free, provided the money has been in the Roth account for at least five years.

If you decide you need the money before that, you can withdraw your original contributions tax-free, but any earnings are subject to taxes and a 10% penalty.

You may be able to avoid this penalty if you take out the money to buy, build, or rebuild your first home or have a permanent disability.

Unlike traditional IRAs, you are not required to ever take money out of your account, and you can leave your account to your beneficiaries. As long as they are at least 59 ½ when they withdraw the money, they will not have to pay taxes on the money either.

What is a Traditional IRA?

A traditional IRA is a retirement account funded with pre-tax dollars. It is set up outside any employer, and thus it gives you the freedom to choose how your money is invested.

There are contribution limits and mandatory distributions once you reach a certain age, but everyone can contribute to an IRA as long as you have an income equal to or greater than your contributions.

Remember that if you can contribute to multiple traditional IRAs or a traditional IRA and a Roth IRA, you are limited to the contribution limits of $6,500 or $7,500 per year depending on your age.

Traditional IRA Contribution Limits

In 2023, you may contribute up to $6,500 per year if you are under the age of 50. That number bumps up to $7,500 per year if you are age 50 or older. This catch-up contribution is designed to encourage those that did not start savings in their younger years.

Traditional IRA Eligibility

Anyone who earns an income can contribute to an IRA.

If you also participate in a 401(k) plan through your employer or earn a high income, the IRS might limit how much you can deduct from your taxes. This should not discourage you from contributing to an IRA if it aligns with your financial goals.

You can continue to contribute to an IRA as long as you have an income, no matter what your age. 

Traditional IRA Withdrawals

You can start withdrawing money when you turn 59 ½, but remember that once you start withdrawing that money, it gets counted as income and you will need to pay taxes.

If you are still working and in a higher tax bracket, you might want to wait until you have a lower income to withdraw funds. You can also withdraw funds and give them directly to a qualified charitable organization. Explore all options with a financial advisor.

Generally, if you are under 59 ½ and you withdraw money from your account, you will need to pay taxes plus a penalty. If you withdraw money to pay for your first home, education, or for a hardship reason, you may be able to avoid the penalty, but not the axes.

If you inherit an IRA from someone else, the same rules apply as if you opened the account yourself.

Traditional IRA Required Minimum Distributions

Once you reach age 72, you are required to take distributions from your IRA. The amount is based on how much you have in your account. A financial advisor or sifting through IRS regulations will help you determine how your withdrawals will affect your taxes.

Roth IRA VS 401(k): What’s the Difference?

Both a 401(k) and Roth IRA offer benefits when saving for retirement, but they could not be more different in their features

What Are 401(k) Plans?

If you work for an employer, they may sponsor a 401(k) plan as part of your benefits package. A typical plan offers a limited amount of investment options, usually in the form of mutual funds, exchange-traded funds, or company stock. 

401(k) contributions are taken out of your paycheck before your income is taxed. Once you start withdrawing funds, you will pay income tax on the contributions and the proceeds.

401(k) Contribution Limits

A 401(k)’s contribution limits are much higher than an IRA’s. If you are under the age of 50, you may contribute up to $22,500 in 2023. If you are aged 50 or older, you may up that contribution to $30,000 per year.

This extra $7,500 is called a catch-up contribution and is designed to encourage those who are nearing retirement age to increase their nest egg.

While it’s a great idea to start contributing to your 401(k) when you are young, not everyone is afforded or takes advantage of this opportunity. Thus, you might want to take advantage of the catch-up contributions.

401(k) Employer Match

Often, employers will sweeten the pot by offering matching contributions. This is usually a percentage of your contribution up to a percentage of your salary.

If you decide not to maximize your contribution to the 401(k), you should at least contribute up to the employer match—otherwise, you are giving up free money. 

There are contribution limits to the 401(k) and this would include what you save combined with what your employer contributed. For 2023, this limit is $66,000 if you are under age 50 and $73,000 if you are age 50 or older.

The difference between the two is the catch-up contribution we mentioned earlier. If your salary is less than the limit, you can contribute 100% of your salary according to the IRS. Limits and matches depend on your company’s plan, so read the fine print.

401(k) and Taxes

When you contribute to your 401(k) you can deduct your contribution from your taxable income. Once you reach retirement age and start taking distributions, you will pay income tax on those withdrawals.

Another perk of a 401(k) is that you can borrow money from your account, and as long as you pay yourself back, you avoid penalties and taxes. 

401(k) Required Minimum Distributions

Once you reach age 72, that following April 1st, you are required to start withdrawing money from your 401(k) plan. This money is taxed just like income. If you fail to withdraw on a schedule directed by the IRS, you may be required to pay a 50% tax penalty. 

Which Retirement Savings Plan is Right For Me?

If you work for an employer and they offer a 401(k) with a matching contribution, take advantage of that benefit and at least contribute up to the match. It’s like getting free money toward your retirement.

Many advisors would also say to contribute the maximum to your 401(k) account if you can afford it. It reduces your income taxes and allows you to contribute a lot more than an IRA. 

If you still want to contribute more to a retirement account, you can open a traditional or Roth IRA. These will allow you to diversify your portfolio with pre-tax and/or after-tax dollars.

Can I Have Multiple Retirement Accounts?

Absolutely! It makes things easier to track your funds if you consolidate them in one place, but they are most likely going to be in several accounts.

A 401(k) can be rolled into a traditional IRA account if you leave that employer. Your Roth IRA would be a separate account, as it is taxed and used differently.

Roth IRA VS Traditional IRA VS 401k: The Bottom Line

Even if you plan to work until you are 90, a retirement account will give you options. And since you never know how life will turn out, it’s best to be prepared.

As you can see, there are numerous options to save for your older years and which one you choose depends on if you work for an employer, how much money you earn, and when you want to pay your taxes. 

There are a lot of resources on this website that will answer your most pressing questions about retirement plans and a lot more financial topics.

 

About the Author Tiffany Aliche

Tiffany “The Budgetnista” Aliche, is an award-winning teacher of financial education, America’s favorite, personal financial educator, and author of the New York Times Bestselling book, Get Good with Money. The Budgetnista is also an Amazon #1 bestselling author of The One Week Budget and the Live Richer Challenge series and most recently, a children's book, Happy Birthday Mali More.

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