Should you contribute to a Roth IRA, traditional IRA, or a 401(k)? We share with you everything you need to know about a Roth IRA, traditional IRA, and a 401(k) to help you decide which one you should contribute to. Your decision can impact how much retirement savings you can accumulate and how much money you will save in taxes. I will also share a bonus tip at the end.
What is an IRA?
An IRA stands for an individual retirement account. The keyword here is individual, meaning you have to set this up by yourself. You can do so through any reputable financial institution. Now, why would you want to open a Roth IRA or a traditional IRA? In a country where nearly half of Americans have less than $10,000 saved in retirement savings, you may want to think about starting to save for retirement early on. The other main benefit is that it can lower your taxes.
What is the difference between a Roth IRA and a Traditional IRA?
The two major differences between a Roth IRA and a Traditional IRA are taxes and withdrawals. Depending on which one you choose, you can either get a tax break now or in the future.
Traditional IRA: A traditional IRA is ideal for those who want an immediate tax break. Traditional IRA contributions can be tax-deductible. If you put $7,000 in a traditional IRA that you just opened and if your income is below a certain amount you get to deduct that from your tax return. Now, let’s say you invest that $7,000 and you manage to grow it over years and years into $100,000, you will not pay taxes on any dividends or any capital gains that you may have generated while it’s inside the traditional IRA. But when you withdraw that $100,000 during retirement, you have to pay taxes on that $100,000 of withdrawal.
Roth IRA: A Roth IRA is a good choice if you’re not eligible to deduct traditional IRA contributions, or if you want tax-free growth on your investments and tax-free withdrawals in retirement. For example, if you put $7,000 in a Roth IRA you don’t get to deduct that from your tax return. However, if you invest it, and that $7,000 grows into $100,000 by the time you retire, you can take out that 100K and pay $0 in taxes. If Nike and FedEx and many other large U.S. companies can pay $0 in taxes, why can’t we, right?
The other main difference between a Roth IRA and a traditional IRA is the flexibility of withdrawals.
Traditional IRA: For a traditional IRA, you cannot take out the money before you’re 59 ½ years old. If you do then you’ll incur a 10% penalty and have to pay federal and state taxes.
Roth IRA: In contrast, Roth IRAs give us flexibility. If you put $7,000 towards a Roth IRA, assuming you’re eligible, and next year you decide that you want to buy a car or a home and you need that extra $7,000 for a down payment. You can actually take out that $7,000 in contributions that you made in the previous year without paying any taxes. This is without paying any penalty. Please be aware that this applies only to your contribution, not your earnings. So, in this example, if that $7,000 becomes $8,000 in one year, you can only take out that $7,000 contribution without taxes and penalties.
Are you trying to decide if you should contribute to your Roth IRA vs Traditional IRA? Here’s a FREE flowchart to help you decide.
Who is eligible to contribute to a Roth IRA & Traditional IRA?
Before you contribute to an IRA, you must check that you are eligible first. For a Roth IRA, there are two main criteria. The first one is that you need to have earned income. In other terms, you must have a job and be getting paid. If you left your job to focus on raising your child for an entire year and you didn’t have income, you cannot contribute to a Roth IRA. The second criteria is that your income needs to be below a certain amount. To contribute to a Roth IRA in 2024, single tax filers must have a modified adjusted gross income (MAGI) of less than $161,000. If married and filing jointly, your joint MAGI must be under $240,000 in 2024. If you are eligible and planning to contribute to a Roth IRA, make sure you watch our video on the three common mistakes with Roth IRAs.
For a traditional IRA, the only criteria is that is you need to have earned income, either a W-2 or 1099. Regardless of how much money you make, you can contribute to a traditional IRA. Now, if your income is below a certain amount, as I mentioned earlier, you get to deduct that contribution from your tax return. If your income is above that limit you can still contribute to a traditional IRA but you cannot deduct it from your tax return. This is essentially called a nondeductible traditional IRA. This is a key step in doing what’s called a backdoor Roth IRA.
What is a 401(k)?
A 401(k) is also a retirement plan that has tax benefits. The main difference with an IRA is that you can only contribute if your employer is offering one. This is actually a huge problem in our country because more than a third of private-sector workers do not have access to a 401(k). So if you do have access to one, don’t take it for granted. There is a solo 401(k) for small business owners. We have a separate video on solo 401(k)s if you want to learn more.
Now, how does a regular 401(k) work? Once you decide to sign up for a 401(k), you need to decide how much you’re going to contribute per paycheck. It can be 1% of your paycheck, 5%, 10%, 20%. It’s really up to you. Once you decide how much you are going to contribute to your 401(k) then your employer will automatically deduct that money from your paycheck and deposit it to your own 401(k) account.
There is a limit on how much money you can contribute per year. The IRS sets that contribution limit each year. The 401(k) contribution limit for 2024 is $23,000 if you are under age 50, and $32,500 if you are 50 or older. Don’t worry if you did the math wrong for some reason, your employer will usually automatically stop the contributions for you once you hit the limit. The nice thing about a 401(k) is most employers will offer an employer matching program.
What does this employer matching mean? Essentially it means free money. Your employer will give you free money if you contribute to this 401(k). For example, if you contribute $100 per paycheck, then your employer might also put in $50 or $100 towards your 401(k). This is a fantastic benefit of a 401(k). You can also invest that money that you’re putting into your 401(k), in stocks or bonds. You have control over how it’s invested. If you do not choose how it’s invested then your employer will choose it for you.
A 401(k) also has tax benefits depending on the type of 401(k) that you choose. It can either grow tax-deferred or it can grow tax-free.
Can you contribute to a 401(k) and IRA at the same time?
Yes! They are two completely separate accounts and you can contribute to them at the same time. You can even decide to max out your 401(k) and max out your IRA if you’re really motivated to retire early.
Should I contribute to a 401(k) or an IRA first?
If your company offers a 401(k) with a company match then it will be in your best interest to put enough money in your 401(k) to get the maximum match. A company matching program is one of the major benefits of a 401(k). This is essentially collecting free money. Once that match is maxed out then you can decide to max out your IRA for the year. After that is maxed out then you can return to your 401(k) and resume your contributions there. Please note that employer contributions are not part of the 401(k) annual contribution limit.
If your employer doesn’t offer a company match then you should consider starting with a traditional IRA or a Roth IRA. This way you will avoid the administrative fees that some 401(k)s charge. Once you have reached the IRA contribution limit for that year then you could contribute to a 401(k) for the pre or post-tax benefits.
If you really want to contribute to a Roth IRA to grow your money tax-free but you’re no longer eligible to do so because of your income, there’s actually a legal tax loophole. This is called a backdoor Roth IRA.
Roth IRA, Traditional IRA, and a 401(k) are the three most popular retirement saving accounts.
They are all fantastic options for retirement savers. You can use more than one of these to maximize your annual contribution. As always, the earlier you start saving, the more you can benefit from compound interest, and be on track to early retirement.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.