Retirement Planning: 401(k) vs. Roth IRA vs. Traditional IRA

We all need to plan for retirement, and it’s never too early to start. Everyone should be disciplined about saving, and although putting money in a savings account is always a good idea, you want to consider long-term strategies as part of retirement planning. Putting money into a 401(k) plan, a Roth individual retirement account (IRA), or a Traditional IRA as part of retirement planning is smart, but it’s important to understand the similarities and differences between each.

Anyone with any sort of income can contribute to a retirement plan, and whether you contribute a little or a lot, it’s good to start as soon as you can. Recent reports show that 67 percent of Americans expect to outlive their retirement savings, and 21 percent have nothing saved for retirement. The average savings are $84,821, which is not nearly enough for retirement.

Maintaining a savings discipline is essential to retirement planning, and a 401(k), Traditional IRA or a Roth IRA can help. The type of retirement account that is best for you depends on your circumstances and your goals.

Divergent Strategies for Retirement Planning

When you consider putting money into a 401(k), a Roth IRA, or a Traditional IRA, you are looking at three very different tools for retirement saving:

A 401(k) plan is an employer-sponsored retirement savings plan that deducts money from your paycheck before you pay taxes. This tax-deferred savings plan was created to supplement retirement pensions, and you can choose how to invest the money for the future, whether it’s in stocks, bonds, mutual funds, or some combination.

A Roth IRA is established with a bank, credit union, or investment broker and allows you to put away retirement savings after you pay taxes (i.e., the money is tax-free when you use it later because the taxes already have been paid). Roth IRAs can be very useful for retirement planning, especially if you believe your tax bracket will be higher as you reach retirement age. You can contribute to a Roth IRA at any time using earned income.

A Traditional IRA is designed to help you put away tax-deferred money for retirement. To qualify, you must be working and under age 70, but IRA tax benefits may not be available if you get 401(k) benefits from your employer. With an IRA, you pay the taxes when you withdraw the savings.

Understanding the Pluses and Minuses

Of course, each of these instruments has its pluses and minuses.

A 401(k) can be extremely valuable if you have trouble saving. Money is withdrawn automatically from your paycheck and set aside so you don’t even have to think about it. Saving with a 401(k) is even more attractive if your employer includes matching funds; you can double your money. Even if you are only allocating a small percentage of your income to a 401(k), it definitely can be worth it.

For example, let’s assume you make $100,000 each year and your company matches your contribution up to 3 percent. If you put $3,000 in your 401(k), they will match it with $3,000 for a total of $6,000 saved. Every 401(k) plan is structured differently, and most companies put a limit on matching funds (e.g., no more than 3 percent). However, you get the added benefit of earning interest income on 401(k) investments and doubling your savings with the help of your employer.

Of course, since this money is set aside for retirement, you can’t access it for other purposes, such as a family emergency. You will vest over time, so once you have been with the company for a specified period, you can access your 401(k) funds. However, because 401(k) savings are pre-tax, or tax-deferred (i.e., you don’t pay taxes until you tap into those savings dollars), when you vest or cash out your 401(k), you have to pay income tax on any money you withdraw.

A 401(k) has the added advantage of allowing you to save more money; up to $18,500 per year, or $24,500 if you are over age 50. If you can afford it, your 401(k) plan can help you accumulate a nice retirement nest egg.

A Traditional IRA, on the other hand, has a tax-deferred contribution limit of $6,000 per year starting in 2019 ($7,000 for those over 50). With a Roth IRA, you have the same limits, but you pay the taxes when you invest. There also are additional restrictions on Roth IRAs based on income; generally, the more you make, the less you can contribute.

In addition to the taxes being paid up front, with a Roth IRA you get a larger selection of investment options without having to rely on an administrator.

You Don’t Have to Choose

So which is best for your retirement savings, a 401(k), a Roth IRA, or a Traditional IRA? If your employer is matching retirement savings, start with a 401(k) and take advantage of the extra cash, up to the maximum amount, and the tax deduction. If your employer doesn’t offer a 401(k) match, go straight to the Roth IRA, with its greater flexibility and tax-free withdrawals.

Or why not do both? There is no reason not to optimize your retirement savings by taking advantage of employer-matching 401(k) contributions and making contributions to a Roth IRA as well. You can contribute to a Roth IRA at any time. In fact, many companies offer Roth 401(k) plans as a retirement planning option so you can even set aside an amount each pay period to build your Roth retirement savings. Maxing out your employer’s 401(k) match and contributing to a Roth IRA could offer the best tax advantages.