{"id":114335,"date":"2019-08-12T14:30:47","date_gmt":"2019-08-12T20:30:47","guid":{"rendered":"https:\/\/www.biggerpockets.com\/blog\/?p=114335"},"modified":"2024-02-13T18:43:22","modified_gmt":"2024-02-14T01:43:22","slug":"401k-versus-roth-ira-pros-cons","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/401k-versus-roth-ira-pros-cons","title":{"rendered":"Traditional 401(k) vs. Roth IRA: Which One Wins?"},"content":{"rendered":"<p>Did you know the average American has only $96,000 saved for retirement? This amount is not nearly enough!<\/p>\n<p>It\u2019s never too late to start saving, but it\u2019s better to start preparing for your retirement as early as possible.<\/p>\n<p>Traditional 401(k)s and Roth IRAs are both very popular types of retirement accounts, and hopefully after reading this article, you\u2019ll know which one is better for you. Or maybe you\u2019ll want both!<\/p>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone wp-image-114349 size-main-slider\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Picture-3-702x336.jpeg\" alt=\"\" width=\"702\" height=\"336\" title=\"\"><\/p>\n<h2>What Is a Traditional 401(k)?<\/h2>\n<p>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.<\/p>\n<h2>Pros and Cons of 401(k)s<\/h2>\n<p><strong>Pros:<\/strong><\/p>\n<ul>\n<li><strong>Tax Deferral \u2013<\/strong> The money you invest is pre-tax, so your contribution decreases your taxable income.<\/li>\n<li><strong>High Contribution Limits \u2013<\/strong> $19,000 per year if 49 years old or younger. $25,000 if 50 or older. Employer contribution does not count toward the limit.<\/li>\n<li><strong>Matching \u2013<\/strong> Employers are allowed to match your contribution.<\/li>\n<li><strong>Withdrawal \u2013<\/strong> Early withdrawal without taxation is allowed in the event of financial hardship or becoming totally disabled.<\/li>\n<li><strong>Rollover \u2013<\/strong> You can roll over your 401(k) to a traditional IRA or Roth IRA after leaving your employer or reaching retirement.<\/li>\n<li><strong>Loan \u2013<\/strong> If your employer permits it, you can take out loans up to 50 percent of your vested balance or $50,000, whichever is less.<\/li>\n<\/ul>\n<p><strong>Cons:<\/strong><\/p>\n<ul>\n<li><strong>Distribution Tax \u2013<\/strong> 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.<\/li>\n<li><strong>Limited Flexibility \u2013<\/strong> Limited number of funds to invest in.<\/li>\n<li><strong>Taxable Income Upon Withdrawal \u2013 <\/strong>Early withdrawal is taxed up to 20 percent plus a 10 percent penalty if you withdraw before age 59.5.<\/li>\n<li><strong>Required Withdrawals at Age 70.5 \u2013<\/strong> Plan holder must start receiving distribution by age 70.5.<\/li>\n<li><strong>Loan Payback \u2013 <\/strong>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.<\/li>\n<\/ul>\n<p><strong><em>Related:<\/em><\/strong><em> <a href=\"https:\/\/www.biggerpockets.com\/blog\/what-to-do-with-your-401k\" target=\"_blank\" rel=\"noopener noreferrer\">Growing Your 401k vs. Liquidating it to Invest in Real Estate: What\u2019s More Profitable?<\/a><\/em><\/p>\n<h2>What Is a Roth IRA?<\/h2>\n<p>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.<\/p>\n<p><strong>Pros:<\/strong><\/p>\n<ul>\n<li><strong>Tax-Free \u2013 <\/strong>The distribution does not count as additional income and is not taxed. This tax treatment also applies to a Roth 401(k).<\/li>\n<li><strong>More Investing Options \u2013 <\/strong>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). <span style=\"font-weight: 400;\">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.<\/span><\/li>\n<li><b>Does Not Require Withdrawals at Age 70.5 \u2013<\/b><span style=\"font-weight: 400;\"> Unlike a 401(k), the account holder isn\u2019t required to withdraw during his\/her lifetime; however, a required minimum distribution (RMD) is required after the plan holder\u2019s death.<\/span><\/li>\n<\/ul>\n<p><strong>Cons:<\/strong><\/p>\n<ul>\n<li><strong>Limited Annual Income \u2013 <\/strong>Limited to people with modified adjusted gross income (MAGI) under $137,000, or $203,000 if you\u2019re married, filing jointly.\u00a0<span style=\"font-weight: 400;\">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.<\/span><\/li>\n<li><strong>Post-Tax Contribution \u2013 <\/strong>Unlike traditional IRA or 401(k), post-taxed dollars are used for Roth IRA and Roth 401(k) contributions.<\/li>\n<li><strong>Taxable Income Upon Withdrawal \u2013 <\/strong>Early withdrawal before age 59.5 is taxed as additional gross income plus an additional 10 percent tax penalty.\u00a0<span style=\"font-weight: 400;\">However, only the capital gains are taxed. The contributions were already taxed once, so it\u2019s not subject to early withdrawal tax.<\/span><\/li>\n<li><strong>Low Contribution Limit \u2013 <\/strong>Annual contribution limit is $6,000, or $7,000 if you\u2019re age 50 or older.<\/li>\n<\/ul>\n<h3>Similarities and Differences Between 401(k)s and Roth IRAs<\/h3>\n<p>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.<\/p>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-114557\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/jay-chang-chart.jpg\" alt=\"\" width=\"702\" height=\"434\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/jay-chang-chart.jpg 702w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/jay-chang-chart-300x185.jpg 300w\" sizes=\"auto, (max-width: 702px) 100vw, 702px\" \/><\/p>\n<h2>Theoretical Earnings for the Traditional 401(k) and Roth IRA<\/h2>\n<p>Below is what each type of account would amount to assuming the following:<\/p>\n<ul>\n<li><strong>Tax Rate:<\/strong> 25%<\/li>\n<li><strong>Annual Investment:<\/strong> $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.<\/li>\n<li><strong>Annual IRR:<\/strong> 8%<\/li>\n<li><strong>401(k):<\/strong> Tax-deferred savings are invested in a mutual fund that also generates 8% annual return, and the investment is not sold until age 60.<\/li>\n<li><b>Employer Contribution:<\/b><span style=\"font-weight: 400;\"> 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.<\/span><\/li>\n<li><strong>Withdrawal:<\/strong> All investments are withdrawn at age 60 to avoid early withdrawal penalties.<\/li>\n<\/ul>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-114344\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Projection.png\" alt=\"\" width=\"742\" height=\"352\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Projection.png 742w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Projection-300x142.png 300w\" sizes=\"auto, (max-width: 742px) 100vw, 742px\" \/><\/p>\n<h3>A) Scenario 1 \u2013 Same Tax Rate at Age 60<\/h3>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-114339\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Scenario-1.jpg\" alt=\"\" width=\"833\" height=\"118\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Scenario-1.jpg 833w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Scenario-1-300x42.jpg 300w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Scenario-1-768x109.jpg 768w\" sizes=\"auto, (max-width: 833px) 100vw, 833px\" \/><\/p>\n<p>In this scenario, the difference between the traditional versus Roth distribution is $104,917.89 (in favor of the Roth account).<\/p>\n<h3>B) Scenario 2 \u2013 Higher Tax Rate at Age 60<\/h3>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-114337\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Scenario-2.jpg\" alt=\"\" width=\"823\" height=\"141\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Scenario-2.jpg 823w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Scenario-2-300x51.jpg 300w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Scenario-2-768x132.jpg 768w\" sizes=\"auto, (max-width: 823px) 100vw, 823px\" \/><\/p>\n<p>In this scenario, the difference between the traditional versus Roth distribution is $314,753.67 (in favor of the Roth account).<\/p>\n<h3>C) Scenario 3 \u2013 Lower Tax Rate at Age 60<\/h3>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-114338\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Scenario-3.jpg\" alt=\"\" width=\"833\" height=\"146\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Scenario-3.jpg 833w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Scenario-3-300x53.jpg 300w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/Scenario-3-768x135.jpg 768w\" sizes=\"auto, (max-width: 833px) 100vw, 833px\" \/><\/p>\n<p>In this scenario, the difference between the traditional versus Roth distribution is $104,917.89 (in favor of the traditional).<\/p>\n<p><strong><em>Related:<\/em><\/strong><em> <a href=\"https:\/\/www.biggerpockets.com\/blog\/2016-06-14-use-real-estate-retirement\" target=\"_blank\" rel=\"noopener noreferrer\">How to Use Real Estate to Retire MUCH More Comfortably Than Your 401k Would Allow<\/a><\/em><\/p>\n<p>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\u2019s distribution at age 60 is greater by almost $105,000, and this difference increases as the future tax rate increases.<\/p>\n<p>On the other hand, if the expected tax rate at age 60 is lowered to 15 percent, then the traditional 401(k)\u2019s distribution would be greater by nearly $105,000 instead.<\/p>\n<h2>So\u2026 Traditional 401(k) or Roth IRA?<\/h2>\n<p>It\u2019s 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.<\/p>\n<p>It\u2019s difficult to predict what your tax rate will be in the future, so I recommend making the decision based on your current tax rate. <span style=\"font-weight: 400;\">Nevertheless, it\u2019s recommended to take advantage of your employer\u2019s contribution. It\u2019s free money after all! No tax advantage can beat this.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.<\/span><\/p>\n<p>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.<\/p>\n<p><a href=\"https:\/\/www.biggerpockets.com\/moneyshow\" target=\"_blank\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-114405\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/money-podcast-ad-v2.jpg\" alt=\"\" width=\"706\" height=\"125\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/money-podcast-ad-v2.jpg 706w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/money-podcast-ad-v2-300x53.jpg 300w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2019\/08\/money-podcast-ad-v2-702x125.jpg 702w\" sizes=\"auto, (max-width: 706px) 100vw, 706px\" \/><\/a><\/p>\n<p><em>Which retirement accounts do you currently own? Do you plan on switching to something else after reading this article? If so, which type?<\/em><\/p>\n<p><strong> Let me know your thoughts in a comment below!<\/strong><\/p>\n","protected":false},"excerpt":{"rendered":"<p>Did you know the average American has only $96,000 saved for retirement? This amount is not nearly enough! It\u2019s never too late to start saving or to bump up your savings rate. But which type of retirement account is best? Find out here. <\/p>\n","protected":false},"author":286556,"featured_media":114401,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[7398],"tags":[],"class_list":["post-114335","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-retirement"],"acf":[],"comment_count":0,"_links":{"self":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/114335","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/users\/286556"}],"replies":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/comments?post=114335"}],"version-history":[{"count":0,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/114335\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media\/114401"}],"wp:attachment":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media?parent=114335"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/categories?post=114335"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/tags?post=114335"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}