Traditional 401(k) vs. Roth IRA: Which One Wins?
Did you know the average American has only $96,000 saved for retirement? This amount is not nearly enough!
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It’s never too late to start saving, but it’s better to start preparing for your retirement as early as possible.
Traditional 401(k)s and Roth IRAs are both very popular types of retirement accounts, and hopefully after reading this article, you’ll know which one is better for you. Or maybe you’ll want both!
What Is a Traditional 401(k)?
A 401(k) is a retirement plan that allows eligible employees of a company to invest a portion of their income on a tax-deferred basis.
Pros and Cons of 401(k)s
- Tax Deferral – The money you invest is pre-tax, so your contribution decreases your taxable income.
- High Contribution Limits – $19,000 per year if 49 years old or younger. $25,000 if 50 or older. Employer contribution does not count toward the limit.
- Matching – Employers are allowed to match your contribution.
- Withdrawal – Early withdrawal without taxation is allowed in the event of financial hardship or becoming totally disabled.
- Rollover – You can roll over your 401(k) to a traditional IRA or Roth IRA after leaving your employer or reaching retirement.
- Loan – If your employer permits it, you can take out loans up to 50 percent of your vested balance or $50,000, whichever is less.
- Distribution Tax – The distribution will count as additional income and will be taxed. The amount of tax is based on your income tax rate at the time, so the rate may be higher or lower than your current tax rate.
- Limited Flexibility – Limited number of funds to invest in.
- Taxable Income Upon Withdrawal – Early withdrawal is taxed up to 20 percent plus a 10 percent penalty if you withdraw before age 59.5.
- Required Withdrawals at Age 70.5 – Plan holder must start receiving distribution by age 70.5.
- Loan Payback – Loan must be repaid within five years and you need to pay interest on the loan; however, the interest payments are added to your investment balance. The interest rate is comparable to the rate charged by lending institutions. You must repay your loan through payroll deductions.
What Is a Roth IRA?
A Roth IRA is a retirement account that allows a person to set aside after-tax income up to a specified amount each year for investments.
- Tax-Free – The distribution does not count as additional income and is not taxed. This tax treatment also applies to a Roth 401(k).
- More Investing Options – You can easily open up an IRA account with various financial institutions, such as Vanguard and Fidelity. You also have more investment options (i.e., more variety of mutual funds and the option to purchase stocks or investment properties). To purchase investment properties, you need to open up a self-directed Roth IRA, and the account takes about 10 business days to set up. Any capital gains for this account are also tax-free.
- Does Not Require Withdrawals at Age 70.5 – Unlike a 401(k), the account holder isn’t required to withdraw during his/her lifetime; however, a required minimum distribution (RMD) is required after the plan holder’s death.
- Limited Annual Income – Limited to people with modified adjusted gross income (MAGI) under $137,000, or $203,000 if you’re married, filing jointly. High income earners can still invest in Roth IRAs by converting a traditional IRA to Roth, but this conversion will be taxed at your regular income rate.
- Post-Tax Contribution – Unlike traditional IRA or 401(k), post-taxed dollars are used for Roth IRA and Roth 401(k) contributions.
- Taxable Income Upon Withdrawal – Early withdrawal before age 59.5 is taxed as additional gross income plus an additional 10 percent tax penalty. However, only the capital gains are taxed. The contributions were already taxed once, so it’s not subject to early withdrawal tax.
- Low Contribution Limit – Annual contribution limit is $6,000, or $7,000 if you’re age 50 or older.
Similarities and Differences Between 401(k)s and Roth IRAs
The Venn diagram below illustrates how these two types of retirement accounts are similar and how they differ, with the overlapping part of the circle representing that which they have in common.
Theoretical Earnings for the Traditional 401(k) and Roth IRA
Below is what each type of account would amount to assuming the following:
- Tax Rate: 25%
- Annual Investment: $6,000 ONLY for both retirement accounts, even though 401(k) has a higher contribution limit. The annual investment starts at age 21 and stops at age 60.
- Annual IRR: 8%
- 401(k): Tax-deferred savings are invested in a mutual fund that also generates 8% annual return, and the investment is not sold until age 60.
- Employer Contribution: The 401(k) projection does not take employer contribution into account. You should always take advantage of the employer contribution. This projection comparison is for the unmatched contribution.
- Withdrawal: All investments are withdrawn at age 60 to avoid early withdrawal penalties.
A) Scenario 1 – Same Tax Rate at Age 60
In this scenario, the difference between the traditional versus Roth distribution is $104,917.89 (in favor of the Roth account).
B) Scenario 2 – Higher Tax Rate at Age 60
In this scenario, the difference between the traditional versus Roth distribution is $314,753.67 (in favor of the Roth account).
C) Scenario 3 – Lower Tax Rate at Age 60
In this scenario, the difference between the traditional versus Roth distribution is $104,917.89 (in favor of the traditional).
Based on the results of the first scenario, where one would be subjected to the same tax rate at age 60, a Roth IRA is a better investment than a traditional 401(k). The Roth IRA’s distribution at age 60 is greater by almost $105,000, and this difference increases as the future tax rate increases.
On the other hand, if the expected tax rate at age 60 is lowered to 15 percent, then the traditional 401(k)’s distribution would be greater by nearly $105,000 instead.
So… Traditional 401(k) or Roth IRA?
It’s better to invest in a Roth IRA early on in your career while your tax rate is still relatively moderate. As time goes on and you start earning more income, your tax rate will increase. At that point, consider allocating more money to your traditional 401(k) to reduce your taxable income.
It’s difficult to predict what your tax rate will be in the future, so I recommend making the decision based on your current tax rate. Nevertheless, it’s recommended to take advantage of your employer’s contribution. It’s free money after all! No tax advantage can beat this.
Even though your current MAGI is greater than $137,000, you can still invest in a Roth IRA through the backdoor method, which is essentially converting your traditional IRA to a Roth IRA.
Lastly, instead of a traditional 401(k), you can choose to invest in a Roth 401(k), which gives you the same tax treatment as a Roth IRA, meaning that the distribution is not taxable. Unlike a Roth IRA, a Roth 401(k) is available to individuals earning more than $137,000 MAGI, as well.
Which retirement accounts do you currently own? Do you plan on switching to something else after reading this article? If so, which type?
Let me know your thoughts in a comment below!