Roth or Traditional, 401(k) or IRA? Which One Should You Choose?

401(k) vs IRA

The answer to the question 401(k) or IRA isn’t one or the other but rather both. These two investment vehicles have attributes that should be used in conjunction with one another. Let’s take a look at what both have to offer, their advantages, and some of their limitations:

401(k) Highlights

A traditional 401(k) is a tax-advantaged, employee-sponsored, defined-contribution retirement account. A defined contribution plan means that both the employee and/or the employer can make regular contributions to the account. These contributions can then be invested into mutual funds, earning interest. Key advantages include:

1. Tax Advantaged: Contributions are usually tax deductible and grow in the account tax deferred. Taxes won’t be applied until you begin making withdrawals in retirement and then, withdrawals will be taxes as ordinary income.
2. Employer Matched: Over 90% of employers offer some sort of 401(k) match with most being between 4-6% dollar-for-dollar matches.
3. High Contribution Limit: The annual contribution limit for most employees is $23,000. The catch-up contribution limit for those over 50 is up to $30,500.

One important feature to remember regarding a 401(k) is that funds are not intended to be withdrawn before the age of 59 1/2 and doing so will result in a penalty of 10% as well as being subject to income tax. There are a couple of disadvantage that should be known as well:

1. RMDs: A 401(k) is subject to required minimum distributions after the age of 73. This is exactly what it sounds like: a minimum distribution that you are required to take each year (after 73) depending on your account balance and your age.
2. Limited Investing Options: Investing options are limited to the mutual funds (or ETFs) your employer offers
3. Vesting Schedules: The fine print regarding that employer match is that that money isn’t totally yours until you’re fully vested. Employers have vesting schedules (graded or cliff) ranging from 1-6 years and until you meet that point, either a percentage or all of your employer contributions will go back to your employer if you leave.

IRA Highlights

An Individual Retirement Account, IRA for short, is a tax-advantaged personal retirement savings account. There are many different types of IRAs but let’s focus on a traditional IRA. Key advantages include:

1. Tax Advantaged: Contributions are usually tax deductible and grow in the account tax deferred. Taxes won’t be applied until you begin making withdrawals in retirement and then, withdrawals will be taxed as ordinary income.
2. Entirely Yours: an IRA is not an employee sponsored retirement account so all contributions (and growth) are yours from the moment they enter your account.
3. More Investment Options: an IRA has a wide range of investment options including stocks, bonds, ETFs, mutual funds, real estate holdings, and commodities.

There are a few disadvantages to IRAs to keep in mind as well:

1. Age Restrictions: Like a 401(k), funds can’t be withdrawn penalty free until 59 1/2.
2. Lower contribution limits: As of 2024, contributions are limited to $7,000 per year with a catch-up limit for those over 50 of $1,000
3. RMDs: Like 401(k)s, IRAs are subject to required minimum distributions after age 73.

Here is a table to highlight these accounts and their attributes:

What is a Roth 401(k) or IRA?

A Roth account is an account that is made of after-tax contributions and grows tax free. All distributions in retirement are tax free. Some employers offer a Roth 401(k) option and Roth IRAs are eligible to individuals who meet the income restrictions. Currently, income limitations are $146,000 for single filers and $230,000 for joint filers. After this income threshold, contribution limits begin being reduced.

I opt for the Roth account for most situations for a couple of reasons. First, Roth accounts are an excellent choice for those who expect to be in a higher tax bracket in retirement, lowering your overall tax burden by being taxed now. Second, there are no required minimum distributions on Roth accounts! This is a huge advantage as RMDs can become quite burdensome once you’ve amassed a bit of wealth. Third, Roth IRAs are tax free for heirs. A traditional IRA can become a tax burden on your heirs, so if you’re planning on leaving money for your children or grandchildren a Roth account can help alleviate that burden. Overall, both traditional and Roth accounts have their advantages and limitations, so consider your retirement goals to figure out which option is best for you.

Which order should I contribute to each account?

Keep in mind that every person’s situation is unique, but this is how I recommend contributing to these accounts.

1. Roth 401(k) or Traditional 401(k) up to the match: If your employer offers a 401(k) match, you want to make sure you’re meeting it. That’s part of your compensation and not meeting that match is throwing away money! If your employer offers a Roth option, I recommend that for the reasons stated above.
2. Max out your (Roth) IRA: After meeting your employer match, you want to max out your Roth IRA. Keep in mind the annual contribution limit is $7,000, whether you choose Roth or traditional or a mix of both. I recommend maxing out your IRA before your 401(k) because you have more control over your investments.
3. Let’s get back to that 401(k): After maxing out your Roth IRA, let’s go back to the 401(k) and up those contributions. You can contribute up to $23,000 to this account, whether Roth or traditional. Another account to take into consideration is your brokerage account. This may be the time where you redirect some of those contributions to a non tax-advantaged brokerage account. The main reason for this is because there is no age limits to withdrawals. Again, consider your long-term and retirement goals. If you’re trying to retire before 59 1/2, having some of your investments in a more liquid account should likely be part of your plan

So, as I said at the beginning of this post, it isn’t really a question of which investment vehicle is the best option for you but rather how you should use all of your options together to meet your retirement goals. I hope this post helped you understand these accounts and their attributes. Let me know your thoughts below.