Which retirement account is best for you?

The world of personal investing, finance and retirement is filled with acronyms: traditional IRA, Roth IRA, 401(k), RMD, APR, ETF, FDIC and so many more. While they may seem intimidating, a degree in finance is not required to understand the three key retirement accounts that you likely already have access to: a traditional IRA, Roth IRA and a 401(k) plan. 

All three of these plans are considered “tax-advantaged” plans. This means your investments offer tax benefits in the form of tax exemptions or tax deferrals. As many know, taxes can eat up a significant portion of your retirement income and your retirement strategy should account for this. 

Understanding the differences between these accounts and knowing which one (or combination) is best for you and your family could be the key to a long-lasting and stress-free retirement.

401(k)

This is a plan that is generally offered through an employer. You can make tax-free contributions to this plan through automatic payroll withholding. Essentially, this plan automatically contributes or invests a certain percentage of your payroll each month. Depending on your plan, you can then set up these contributions to be allocated to different investments that your plan offers. You can contribute any percentage of your salary to this plan, but there are annual contribution limits. For 2020, if you are under 50 years old, the limit is $19,500. If you are 50 or older, you can contribute up to $26,000.

401(k) Pros

  • Income grows tax-free allowing for larger initial investments and potentially larger growth.
  • Many employers will match a certain amount of your contribution—essentially free money for you.
  • There is a large annual contribution limit which offers the largest tax advantage compared to Roth IRAs and traditional IRAs.
  • Distributions are potentially taxed when you are in a lower tax bracket in retirement.

401(k) Cons

  • Limited investment choices.
  • Distributions are taxed as ordinary income.
  • Due to the costs of running a 401(k) program, they often include high account fees.
  • You are required to start taking Required Minimum Distributions (RMDs) at age 72.
  • Early withdrawal fees if you take distributions prior to 59.5 years of age.

As a bare minimum, you should consider contributing enough to get 100% of the money your company will match. This is essentially “free money” you can use to invest in your future.

Traditional IRA

Individual retirement accounts, also known as IRAs, are similar to 401(k) plans as they’re both tax-advantaged investment vehicles. There are two main flavors of IRAs, the traditional IRA, and the Roth IRA. With a traditional IRA, similar to a 401(k) plan, you contribute pre-tax dollars. This allows your money to grow tax-deferred, meaning you do not pay taxes on your original contribution or your earnings until you start taking withdrawals. Contributing a larger amount of money up-front due to taxes being deferred not only allows you to potentially achieve higher lifetime returns (due to the power of compounding), but it also opens up the potential to pay taxes when you are retired—often in a lower tax bracket.

Traditional IRA Pros

  • Income grows tax-free, allowing for larger initial investments and potentially larger growth.
  • No income limits.
  • Invest in any accounts offered by your brokerage (stocks, bonds, ETFs, mutual funds, etc.).

Traditional IRA Cons

  • Early withdrawal penalty if you withdraw before age 59.5.
  • Distributions are taxed as regular income.
  • Strict total IRA (Roth + traditional) contribution limit of $6,000 if under 50 and $7,000 if 50 or older per year.
  • Required Minimum Distributions (RMDs) are required starting at age 72.

At the end of the day, determining which IRA makes the most sense for you likely comes down to the tax bracket you expect to be in during retirement. If you believe you will be in a lower tax bracket than you are now, it likely makes sense to max out a traditional IRA. This will allow your money to grow tax-free until you take distributions when you are in that lower tax bracket.

Roth IRA

The key difference between a traditional IRA and a Roth IRA is the timing of the tax advantage. With a Roth IRA, you contribute your money post-tax, meaning you pay taxes on the income, and can then invest your money in the account. The benefit comes on the back end. When you withdraw your money, you generally do so tax-free. Another key difference is that Roth IRAs have income limits. This means that if your Modified Adjusted Gross Income (MAGI) is over $124,000, your total contribution limit phases out based on your income. If your MAGI is over $139,000 you are no longer eligible to contribute to a Roth IRA.

See the two charts below that display 2020 contribution limits for all three tax-advantaged accounts, as well as a breakdown of the income limit phase for Roth IRAs.

If your income or your joint income place you in the “phases out” category, you can learn how to calculate your Roth IRA contribution limit using the IRS formula here.

Contribution limits of IRA, Roth IRA and 401(k)

2020 Contribution Limits Traditional IRA Roth IRA 401(k)
Combined limits in all IRA accounts: $6,000 or $7,000 if 50 or older

If under age 50: $19,500

If 50 or older: $26,000

Roth IRA income limits and phase out

Filing Status 2020 MAGI Contribution Limit
Single Less than $124,000 $6,000 ($7,000 if over 50 years old)
$124,000 to $138,999 Phases out
$139,000+ Not eligible
Married Joint Filing Less than $196,000 $6,000 ($7,000 if over 50 years old)
$196,000 to $205,999 Phases out
$206,000+ Not eligible
Married Separate Filing Less than $10,000 Phases out
$10,000+ Not eligible

 

Roth IRA Pros

  • Earnings grow and are withdrawn tax-free.
  • Contributions can be withdrawn at any time tax-free.
  • No Required Minimum Distributions (RMDs).

Roth IRA Cons

  • Taxes are paid upfront, and earnings grow off of post-tax dollars.
  • Income limits may reduce the amount you can contribute.

If you believe you will be in a higher tax bracket when you are ready to withdraw from your account and your income level allows it, the common practice is to max out your Roth IRA. This will allow your money to grow and be withdrawn tax-free once you are ready in retirement.

The most common strategy people take when it comes to retirement accounts is to start with their 401(k) and contribute up to what their employer will match. From there, depending on their income situation, they generally max out their Roth IRA, traditional IRA or a combination of both. If they still have money left over, the next step would be to max out their 401(k) to the total limit. Finally, if they still have money left over to invest, it is recommended to explore a traditional investment (stocks, bonds, ETFs, mutual funds, etc.). However, these investments are not tax-advantaged.

What is right for you?

Where to contribute your retirement funds can be an incredibly complicated, but also a very important decision. What works best for one individual or family does not always work best for the next. Simply Advised works with hundreds of financial professionals nationwide who can review your personal situation and help recommend what the best solution is for you.