IRA vs. 401(k) & Traditional vs. Roth
Gone are the days of working one job and retiring worry free with a pension. Now, most companies have moved to what is called a “defined contribution” plan where, at best, they give you an employer match (if you contribute $X, we’ll contribute $X up to a defined maximum). This means that the burden of retirement falls largely on your ability to accumulate enough savings. Fortunately, there are some vehicles that can aid you in this process.
Why We Should Save
The Power of Compounding Interest
First, we have to highlight the importance of saving for retirement. As you can see from the chart below the sooner you can start saving, the better. This is the beauty of compound interest. The money you save earns a return, and then those returns earn returns, accumulating more and more over time. The more time the money has to grow, the bigger the compounded returns.
To make saving easier, the government established tax advantaged vehicles to encourage people to save. The two most common are the IRA and the 401(k), which we’ll discuss below. Another common vehicle you’ll hear discussed is the “Roth”.
Types of Retirement Savings Vehicles
401(k)s were established under the Employee Retirement Income Security Act (ERISA) of 1974. The 401(k) is an employer-sponsored plan, meaning it is a benefit that your company can choose to provide you. Under the plan, a retirement savings account is set up for the employee and the employee can choose to contribute a portion of their wages from each paycheck into the account. The money in the account is then invested in different investment funds (funds of stocks, bonds, etc.) chosen by the employee and managed by the 401(k) provider that the company has engaged (usually a financial institution like Fidelity, Nationwide, etc.). Some employers offer a “match” where they’ll contribute $1 for each $1 the employee contributes, up to a set amount. This match is not part of the 401(k) but rather an optional benefit some companies provide (if you work at a company that offers this, you should take advantage of it — it’s free money!). The money contributed by the employee goes into an investment account tax free, so if you earn $100k in a year and decide to save $10k in your 401(k), then you’d only have to pay income taxes on the $90k of income. The full $10k goes into the 401(k) and grows in the investment account tax free (you don’t pay capital gains taxes on any investments you sell, or income taxes on any dividends). Then when you retire, you can draw down the money that has accumulated and at that point you pay income taxes on the distributions that you take (the distributions become your income in retirement, at which point you pay income taxes). For 2021, the maximum annual contribution that most people can make to a 401(k) is $19,500 (people above 50 can contribute more).
IRAs are similar to 401(k)s, but an IRA is not employer-sponsored. This means that anyone can open an IRA account (you can open an IRA account with most banks and there are brokers like Fidelity and Charles Schwab that are also great options), regardless of their employer (or lack thereof). IRAs have a smaller annual contribution limit of $6,000 per year (there’s an additional amount for people over 50). The contribution limits can change each year, so you should review the IRS website here to understand how much you can contribute based on your specific situation (there’s other info there as well). The government regulates 401(k)s and so they have to comply with stricter oversight as specified in ERISA. This often means that there are limited investment options in a 401(k) that are chosen by the employer. Since an IRA is not sponsored by an employer, it doesn’t have these limitations and you can typically choose from a wider array of investments. When people leave jobs, they’ll often roll their 401(k) into an IRA. If you have had multiple jobs with multiple 401(k)s, rolling the 401(k)s into an IRA will allow you to consolidate them into one place (so you won’t have to go to multiple websites to manage the investments) and it will give you more investment options than a 401(k).
Note, that some employers will have special retirement vehicles offering pre-specified returns on the money you save (i.e. 5% a year, though these types of structures are increasingly rare). If the employer is a large, creditworthy institution it may make sense to keep those guaranteed returns, so make sure you understand the nuances of your employer-sponsored vehicle before rolling them all into an IRA.
Roth v. Traditional IRAs
A Roth account works slightly differently than a traditional IRA. In our traditional IRA/401(k) example, you earned $100k and decided to save $10k. You wouldn’t owe taxes on that $10k (you’d pay your income taxes on the remaining $90k). The $10k you saved would grow tax free until you retired. When you retire, you will draw down the money from the traditional IRA at which point you will pay income taxes on those distributions (i.e. the withdrawals become your income as a retiree, at which point you pay the income taxes). If you chose a Roth IRA instead, the tax treatment would be the opposite. You would be taxed on the full $100k today. The $10k (net of taxes, since we pay the taxes upfront in a Roth IRA) you decided to save would go into your Roth IRA and would then grow tax free (this part is similar to the traditional IRA). When you withdraw the money from a Roth IRA in retirement, you don’t have to pay income taxes on the withdrawals as you already paid them upfront.
The main difference between the Roth and a traditional IRA primarily boils down to when you owe taxes. If you think your tax rate will be higher in the future, a Roth savings vehicle would make more sense (you’ll prefer to pay taxes today under your lower tax bracket vs. in the future when you expect to be in a higher tax bracket). Typically though, people have lower incomes and thus lower tax brackets in retirement versus when they’re working, and so a traditional IRA would make more sense. Many factors come into play though. For example, if you’re currently working in NYC (high state and city taxes) and you know you’ll retire in Florida (no state income taxes), then a traditional IRA would make more sense. However, with baby boomers retiring and the government needing to cover growing social security and medicare payments, many people think that it’s inevitable that tax rates will go up from the currently low levels. If you’re uncertain how your current tax rate will compare to your future tax rate, you could split your savings between a traditional retirement vehicle and a Roth.
A Final Note…
One notable exception to all of this is for freelancers and independent contractors. Self-employed people don’t have an employer sponsored 401(k) as an option. However, they do have IRAs and two other options — the Solo 401(k) and the SEP IRA, which we’ll potentially discuss in a future post.