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Difference between a Traditional 401K, Traditional IRA, Roth 401K, and Roth IRA
Disclaimer: I am not a registered financial planner nor do I have a degree in finance or accounting. I consider myself an average investor as I know I've made more mistakes than I have made good moves.
As my children begin their careers, there are more choices out there for retirement savings, and it is becoming more difficult to determine who is helping you understand your options and who is just selling you things. This is where I start with my kids as I begin to teach them about investing.
Let's start off with defining some terms.
- 401K. Provided through your employer as an account to save for retirement. You contribute to this account as a percentage of your salary. Many employers provide a match to this account as well. For example, an employer may match 25 cents per dollar up to your first 6% of contributions.
- IRA. Provided through third-party investment firms as an account to save for retirement. You set up the account, and you select the company that holds the account which could be a bank like Chase or Bank of America, or an investment firm like Charles Schwab or Fidelity. You contribute to this account as you see fit.
- Roth Retirement Account. In a Roth retirement account, the money is put into the account after income taxes. Thus, you have paid income taxes on this money. The expectation is that you won't have to pay income taxes when you use the money in retirement.
- Traditional Retirement Account. In a traditional retirement account, the money is put into the account before income taxes. Thus, you do not pay income taxes when you earn the money. The expectation is that you will pay income taxes when you use the money in retirement.
There are a lot of great resources that can tell you about all the rules of each type of account, and I am highlighting the ones above as the assumption is that you are going to use the money only for retirement. Now, let's put these terms together.
- Traditional 401K. An employer-sponsored 401k where contributions are taken out pre-tax.
- Roth 401K. An employer-sponsored 401k where contributions are taken out after tax.
- Traditional IRA. Account at third-party firm whose qualified contributions are tax deductible.
- Roth IRA. Account at third-party firm whose qualified contributions do not provide a tax deduction.
- Company Match. A company match is money the company puts into your 401K account. You typically here it as something like the company will match 50 cents for every dollar you contribute up to 6%.
When to Contribute to a Roth vs a Traditional Retirement Account
Here's the deal, when you contribute to a retirement account you want to minimize the taxes you pay when money goes into the account and when money comes out of the account. And no one talks about what that means. This means that over your life you should contribute to both a Roth and a Traditional retirement account to minimize taxes. You won't contribute to both at the same time, however, there will be a point where you will switch contributing from one to another.
Which one should I contribute?
First, you need to understand how much income taxes you pay today, which is largely tied to your salary. For example, most people making less than $20,000 per year, do not owe any income taxes. In this case, a Roth 401K is perfect. You contribute as much as you can virtually tax free and during withdrawals it is also tax free. As your income goes up, you begin paying income taxes, maybe 5%, but let's assume you'll be paying 10% on the withdrawal. It still makes sense to contribute to a Roth. As usually this is occurring early in your career, the earnings are going to grow for a long time, which are also withdrawn tax free. Conclusion: if you have access to a Roth 401K, use this account in the early part of your career and as you get your first job out of college.
When do you switch to a traditional retirement account from a Roth?
Later in your career, you may have 10 or 15 years left before you retire, you've been promoted a few times and you are paying 15-20% in income taxes. Now may be the time to switch to a traditionally 401K. The money you are putting into a traditional IRA now has a tax savings of 15-20%. Upon withdrawal, the taxes should be lower, say 10%. However, in this case, you will also pay taxes on the earnings. Conclusion: if you have access to a Roth 401K, switch to a traditional 401K when you are closer to retirement and you are in a higher tax bracket.
Best advice is to talk to a tax professional and a financial advisor. However, if either are not thinking about this, it's time to find a new one.
Where do my Company Matching Contribution Go?
Whether you contribute to a Roth 401K or a Traditional 401K, your company matching contributions will go into a tax deferred account. Meaning, you will be paying taxes on all company matching contributions when you withdraw this money.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.