Traditional vs. Roth, 401(k) vs IRA: What the eff is the difference between these?

While you were learning A2+B2=C2  in High School, you didn’t learn about the things I wrote in the title. If that didn’t hook you, I don’t know what will. Screw intros. Here’s the difference between the types of accounts:

401(k) vs IRA:

Both of these are tax-advantaged retirement accounts and you’ve probably heard of both of them. There are subtle, but, important differences. For the sake of the argument below, we will consider both accounts are Traditional and not Roth accounts.

401(k)– Named 401(k) based on where it is located in the IRS tax code. The first thing to know about the 401(k) is that it is only offered via an employer. You can’t contribute to one if your employer does not offer one. The maximum contribution limit is $18,000 as of 2017 if you are under 50 and $24,000 if you are over 55. You can contribute to a 401(k) as long as you are still working. Contributions are pulled directly from your paycheck which reduces your taxable income. Additionally, your employer usually matches a % of how much you contribute. Lastly, the investment options are usually very limited. Typically you are restricted to retirement funds or mutual funds with high fees.

IRA- Stands for Individual Retirement Account. If you have taxable income you are eligible to start an IRA. However, if you make too much money, you lose the tax benefit of contributing. Most of the time the maximum contribution limit is $5,500 a year as of 2017 if you are under 50 and $6,500 if you are over 50 and under 70.5. While there is no matching amount from an employer, you do have a very wide selection of investment options, which allow you to better tailor your portfolio to what you want.

 

While those are both Traditional retirement accounts, you might have the option of a Roth account. A Roth IRA or 401(k) essentially means after-tax dollars. Traditional = pre-tax and Roth = after-tax. Easy as that.

Because these are after-tax dollars, this means you already paid taxes on this money and will not get a tax deduction in the current year. However, the benefit of these types of accounts is that the money grows tax-free while in the account and is distributed tax-free when you pull the money out in retirement. As long as you pull it out after you are 59.5 (unless it’s for a qualified reason), you won’t incur any penalties either.

Here’s a couple of fancy chart detailing key differences:

Trad. 401(k) Roth 401(k)
Eligibility Depends on Employer Depends on Employer
Contribution Limits Age <50: $18,000
Age 50-stop working: $24,000
Age <50: $18,000
Age 50-stop working: $24,000
Taxes Invest pre-tax dollars and pay taxes later. Benefit in current year. Invest after-tax dollars and pay no taxes later. Benefit in year of withdrawal.
Employer Match Yes, if employer offers it Yes, if employer offers it
Invesments Limited Limited

 

Trad. IRA Roth IRA
Eligibility Anyone under 70 with taxable compensation Anyone with taxable compensation
Contribution Limits Age <50: $5,500
Age 50-70.5: $6,500
Age <50: $5,500
Age >50: $6,500
Taxes Invest pre-tax dollars and pay taxes later Invest after-tax dollars and pay no taxes later
Employer Match No No
Invesments Wide Selection Wide Selection

 

A notable caveat: there are certain income limitations for contributions/distributions, tax deductions, etc. However, the above chart details the basics without worrying about these. If you are concerned about the income limitations and phase-outs, use the contact page or comment below to ask and I’d love to explain them further.

Lastly, for traditional accounts, once you are 70.5 you have to take a required minimum distribution (RMD). This means you are required to take a certain amount of money (based on a calculation) from the account each year and count it as income. If you are still working, you can delay the required distribution from your 401(k), but not your IRA. This could affect your taxable income and tax management during retirement. But we’re also talking about a long time from now, so you might just not care that much yet.

There are pro’s and con’s to all types of accounts. I hope the above facts help you decided which would be best for you. Most of the time, young adults choose Roth accounts because their tax bracket is lower now than it will be in the future. But each case is different and what might be good for you might not be good for your friend. So do your research, ask experts, and make the best choice for you. Cheers to saving money for retirement in tax-advantaged accounts!

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