401k vs IRA & Traditional vs Roth: The Basics | Retirement Savings 101 (2024)

Totally confused about all those retirement terms? Feeling out of the loop? Let’s fix that…

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Starting to save for retirement can feel a little like trying to learn a new language. There are so many terms that you’ve never heard of before, and honestly, it gets confusing.

It took me a few years to truly understand the differences between a 401(k) and an IRA (and the difference between traditional andRoth accounts).

The Shortest Explanation of Retirement Terms Ever:

(Contribution limits are for the year 2020)

401k: you can contribute up to 19,500/year to this retirement savings plan (or $26,000/year if you are older than 50). Your employer sponsors this plan, so you sign up for this at work; your employer may match some of your contributions. There are no income limits to this plan; you can contribute to either a traditional 401k or Roth 401k no matter how much you make.

IRA: you can contribute up to $6,000/year to this retirement savings plan (or $7,000/year if you are older than 50). IRA stands for Individual Retirement Account – the key word is individual, so YOU sign up for an IRA at a bank, credit union, or private company like Fidelity or Vanguard. There are no income limits for contributing to a traditional IRA, but there are income limits for contributions to a Roth IRA (income limits found here).

Traditional: you can have a traditional 401k or a traditional IRA. The term traditional means that the money you put into the retirement account has NOT been taxed yet; you are putting in tax-deferred money. Since you did not pay taxes when you put the money into the account, you must pay taxes on all of money when you take it out (withdraw). All withdrawals are taxed; this includesthe money you originally put in AND the earnings (earnings are the money that your original contribution made as a result of being invested in the stock market).

Roth: you can have a Roth 401k (not very common) or a RothIRA. The term Rothmeans that the money you put into the retirement account has already been taxed. All the withdrawals (all the money you take out when you retire) are tax free (you don’t have to pay taxes on any money you take out). That means you don’t have to pay taxes on any of the earnings (earnings are the money that your original contribution made as a result of being invested in the stock market) – no taxes on your earnings is the major benefit of a Roth 401(k) or Roth IRA.

Which plan is right for you?

Now all of this information is great, but how do you know which retirement savings plan is right for you? I can’t answer that question for you because I don’t know your exact financial situation. However, I can tell you what I do for retirement savings, and my thought-process. It may help you evaluate your situation.

From this article, you know that there are four main types of retirement savings plans: traditional 401(k), Roth 401(k), traditional IRA, Roth IRA.

Traditional 401(k): Myemployer offers a 5% match – this means that if I contribute 5% of my salary to my 401(k), my employer will also contribute that same amount (5%). What a deal! That’s essentially a 5% raise. I always contribute at least 5% of my salary to my traditional 401(k) to take advantage of this match. After funding my second priority (fully funding my Roth IRA, if you read below), I then contribute as much as I can to my traditional 401(k), above and beyond the initial 5%. I try to contribute up to the maximum, which for me is $19,500/year.

Roth IRA: After contributing the initial 5% to my 401(k) (because my employer matches 5%), I fully fund my Roth IRA $6,000/year. There are a few reasons that contributing to a Roth IRA is my second priority: I am very young, so all of the earnings I make over the next 30+ years until I retire will not be taxed (I should have a lot of earnings because my money has so much time to grow); my earnings will be taxed in my traditional 401(k). Also, if I’m being honest, having a mix of traditional and Roth accounts makes me feel comfortable and I like that I’m taking advantage of both tax benefits that the government offers for retirement savings. I will say that I initially started contributing to this account because I thought I was currently in a lower tax bracket than I would be in retirement. This means that I’d pay less taxes on my contribution now that I would if I were to withdraw the money when I retire (plus, all the earnings won’t be taxed). I opened up a Roth IRA at Fidelity and I have tons of options on how to invest (individual stocks, mutual funds, etc). I am still able to fully fund my traditional 401(k).

Roth 401(k): My employer does not offer aRoth 401(k), so I am not able to contribute to one.

Traditional IRA: I do not have a traditional IRA. I prefer to contribute any pre-tax (“traditional”) money to my 401(k) at work – it’s very easy since the money is taken directly out of my paycheck. Also, my traditional 401(k) has very low administrative fees; I would not be able to find a lower or comparable administrative fee if I opened up my own traditional IRA.

All of the money in my retirement savings is invested in the stock market.

Saving for retirement is important!

Saving for retirement is very important. Why? You’ll need money when you retire (for food, utilities…vacations!). After you retire, you won’t have an employer paying you a salary.

It’s also very important to learn about the different types of plans out there, so you can take full advantage of the tax-benefits that certain plans offer.

Have you starting to save for retirement? How did you decidewhich retirement savings account(s) was best for you?

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FAQs

401k vs IRA & Traditional vs Roth: The Basics | Retirement Savings 101? ›

With a traditional IRA, your contributions are pre-tax, just like a 401(k). Your invested funds will be tax-deferred, which means you pay taxes when you withdraw money at retirement. In a Roth IRA, your contributions are after-tax and investments grow tax-free. Your qualified withdrawals in retirement are tax-free.

What is the difference between traditional vs Roth 401k and IRA? ›

Roth 401(k), Roth IRA, and pre-tax 401(k) retirement accounts. Designated Roth employee elective contributions are made with after-tax dollars. Roth IRA contributions are made with after-tax dollars. Traditional, pre-tax employee elective contributions are made with before-tax dollars.

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Should I put my 401k into a traditional IRA or Roth IRA? ›

If you want to keep things simple and preserve the tax treatment of a 401(k), a traditional IRA is an easy choice. A Roth IRA may be good if you wish to minimize your tax bill in retirement. The caveat is that you'll likely face a big tax bill today if you go with a Roth — unless your old account was a Roth 401(k).

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Is it better to put money in 401k or Roth IRA? ›

The Bottom Line. In a 401(k) vs. Roth IRA matchup, a Roth IRA can be a better choice than a 401(k) retirement plan, as it typically offers more investment options and greater tax benefits. It may be especially useful if you think you'll be in a higher tax bracket later on.

Should I split my 401k between Roth and traditional? ›

Should You Split Contributions Between a Roth and Traditional Account? Splitting contributions between a Roth and traditional account can allow you to get some tax benefit today while hedging somewhat against higher tax rates in the future.

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Should high earners use a Roth 401k? ›

Tax diversification: High-income earners often find themselves in higher tax brackets. A Roth 401(k) account gives you more flexibility in managing your tax liability during retirement. Having a Roth account also allows you to be strategic about the tax treatment of your investment choices.

At what age is 401k withdrawal tax free? ›

Once you reach 59½, you can take distributions from your 401(k) plan without being subject to the 10% penalty. However, that doesn't mean there are no consequences. All withdrawals from your 401(k), even those taken after age 59½, are subject to ordinary income taxes.

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How much tax will I pay if I convert my 401k to Roth IRA? ›

You'll owe income tax on the amount you convert from a traditional IRA or 401(k) to a Roth IRA, since you've never paid tax on that income. The amount you convert is added to your gross income for that tax year. The higher the conversion amount, the more you'll owe in taxes.

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Is there a downside to Roth 401k? ›

No tax deferral now. The list of cons may be short for Roth 401(k)s, but missing tax deferral is a big one. When faced with a choice of paying more tax now or later, most people choose to pay later, hence the low participation rates for Roth 401(k)s.

What is a major advantage of the Roth over a 401k? ›

The biggest benefit of the Roth 401(k) is this: Because you already paid taxes on your contributions, the withdrawals you make in retirement are tax-free. That's right! The money you put in—and its growth! —is all yours. No taxes will be taken out when you use that money in retirement.

Is 50 too late for Roth IRA? ›

Roth IRA. You can contribute at any age if you (or your spouse if filing jointly) have taxable compensation and your modified adjusted gross income is below certain amounts (see and 2022 and 2023 limits).

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What is the 5 year rule for Roth IRA? ›

The Roth IRA five-year rule says you cannot withdraw earnings tax-free until it's been at least five years since you first contributed to a Roth IRA account. This five-year rule applies to everyone who contributes to a Roth IRA, whether they're 59 ½ or 105 years old.

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Is 35 too late to start a Roth IRA? ›

Are You Too Old for a Roth IRA? There is no maximum age limit to contribute to a Roth IRA, so you can add funds after creating the account if you meet the qualifications. Roth IRAs can provide significant tax benefits to young people.

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Which is better traditional or Roth IRA? ›

To come out even in terms of after-tax savings, you have to be disciplined enough to invest the traditional IRA tax savings you get every year back into your retirement savings. If that seems unlikely to happen, then you'd be better off saving in a Roth, where you'll arrive at retirement with more after-tax savings. 4.

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Why is Roth IRA better than traditional? ›

With a Roth IRA, you contribute after-tax dollars, your money grows tax-free, and you can generally make tax- and penalty-free withdrawals after age 59½. With a Traditional IRA, you contribute pre- or after-tax dollars, your money grows tax-deferred, and withdrawals are taxed as current income after age 59½.

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Should I switch from traditional 401k to Roth? ›

Do you think you'll be in a higher tax bracket during retirement than you are now? If so, that can be a good reason to switch to the Roth. You'll pay taxes now at a lower tax rate and enjoy tax-free income later when your tax rate is higher.

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