401k, IRA, Roth – Which Is Best For You?

401k IRA Roth

Paper Asset Investing Series: Post #4

I’m doing a paper asset investing series (essentially stock market investing) and in today’s post we are covering different investing platforms.

Check out the other 3 posts here:

Post #3: Understand and Reduce Your Investing Anxiety

Post #2: The Most Important Thing To Know Before You Ever Start Investing

Post #1: Top 5 Investing Terms to Help Beginner Investors Become Smarter Investors

There’s a lot of different investing platforms to choose from. People usually aren’t sure which platform will work best for them or if they should have more than one. They also don’t understand the benefits or drawbacks of each. We are going to discuss 4 different investment platform types today and give what each is and their benefits and drawbacks so you can decide which would work best for you. We are going to talk about: 401k, IRA, Roth 401k and Roth IRA.

Let’s start with the most popular investing platform, a 401k.

What is a 401k

A 401k is an employer sponsored retirement plan.

The most important thing to note about a 401k is you are paying taxes when you withdraw the money from your 401k, not when you put the money in.

You can make contributions to your 401k directly from your paycheck. Your contributions are deducted from your paycheck before your company takes out taxes.

This type of contribution is called a “pre-tax” contribution because the contributions are made before you get taxed on the income.

Essentially, you’ll see the amount you made on your paycheck stub. From that amount, it will show a certain amount being deposited into your 401k. Your full income amount minus how much you contributed to your 401k will be the amount that gets taxed.

Benefits / Drawbacks of a 401k

Being able to contribute toward your retirement is always a benefit and a 401k is one platform to use. By contributing to your 401k this year, you’ll get a tax benefit on your taxes because you won’t be taxed on your full income amount.

A lot of companies will do what’s called a ‘company match’ for their 401k plans. This means if you contribute a certain amount into your 401k, your company will match that percentage (or a part of that percentage).

There’s a lot of different ways companies do a company match so check with your HR director for the exact details on how your plan works.

For example though, if you contribute 6% of your paycheck into a 401k the company could match that 6%. Or sometimes companies will match a certain percentage (like 50%) of what you put in.

A lot of companies will only pay out a portion of that 6% until you are fully vested (essentially meaning you stayed at the company for how many ever years they require). At one of my previous companies employees weren’t fully vested until they had been there 6 years.

So the first year you started the company put in the full match of your 6%, but if you left within 2 years you would only take 2% of their match with you. They would increase that match over the years until you hit your 6th year at the company. They would then let you take the full 6% match if you left.

They are trying to get you stay with the company for at least 6 years with the incentive of having a full match in your 401k. Plans vary from company to company so be sure to check with your employer to see how your 401k plan works.

You can start taking withdrawals from your 401k at age 59½. Generally speaking, if you’re under 50, you can contribute up to $18,000 into your 401k.

You can also borrow against your 401k for a down payment on a house, but be careful. There are a lot of stipulations like paying it back within 5 years or a lot sooner if you end up leaving the company.

You can borrow (or take out a loan) from your 401k. When you borrow from your 401k, you make the repayments with after-tax money. However, as soon as the repayments are deposited back into your 401(k), they become tax-deferred again. When you retire and take that money out for income purposes, you will be taxed on it again. Hence you’ll be double taxed.

A lot of 401k plans are now including funds that are called ‘Retirement-Date Funds.’ These funds make it nice for the hands off type of investor because the fund automatically rebalances itself to become less risky as it gets closer to the retirement date you choose.

On the other hand, companies don’t always have the best investing funds or options within the plan, especially if it’s a smaller company. You want to put your money in funds that meet your criteria, such as one with low fees.

The fees are usually higher in an employee sponsored plan because you’re paying a fee for the management of company’s 401k plan. The guy that comes into explain the plan needs to be paid.

Per IRS regulations, after reaching age 70½, you are generally required to start withdrawing money from a traditional 401k (or IRA for that matter). The amount you have to withdraw is based upon your life expectancy, so you’ll have to continue to increase the amount you are taking out each year.

You’ll also need to start paying taxes when you start withdrawing the money. This may not be a drawback if you aren’t in a higher tax bracket than when you put the money in. It is something to consider because as history shows taxes continue to rise. When you select an amount to start withdrawing when you’re ready, that amount will be taxed as it comes out of your 401k.

What is an IRA

An IRA is another type of retirement account. IRA actually stands for Individual Retirement Account. Since it is an ‘individual’ account it is not tied to your employer.

You can set one up through any brokerage firm. The brokerage firms have different funds or options you can invest in through your IRA. There’s certain mutual, index funds they provide. You can also put stocks and bonds into your IRA.

Most of the larger brokerage firms, like Vanguard and Fidelity, have a lot of options to choose from.

Benefits / Drawbacks of an IRA

An IRA (aka a traditional IRA) is another great way to invest money. Your tax deductions each year will depend on different factors, like how much you earned that year, whether or not you participate in an employer retirement plan, like a 401k, your filing status and whether or not you are getting social security benefits. Investing in a IRA, like a 401k, can offer tax deductions.

You can also borrow against your IRA to purchase a first-time home. Double check with your financial planner about the details because if you withdraw money from a Traditional IRA before the age of 59.5, you can be subject to taxes on the money you take out plus penalties for early withdrawals.

With a Traditional IRA, you are required to start taking out money by the age of 70.5. The government wants their tax money.

You’ll be charged an extra 10% penalty on any funds you take out of a an IRA (or 401k) account before the age of 59½. That’s on top of the ordinary income tax rate you normally pay on distributions.

Just like your 401k, you’ll also need to start paying taxes when you start withdrawing money from your IRA.

If you are under the age of 50 you can contribute up to $5,500 each year and if you are 50 or older you can contribute up to $6,500.

What is a Roth 401k / Roth IRA

When we put the word Roth ahead of IRA or 401k it means you pay taxes on the contributions up front. So when you start contributing money to your Roth IRA or Roth 401k you’ll pay taxes on the money first then it will go into your accounts.

For clarification, when you receive your paycheck, you make a $100 contribution to your Roth IRA. You already paid taxes when you received your paycheck, therefore it is funded with after-tax dollars or ‘post-tax’ contributions.

When you set up a Roth 401k with your employer (if they offer it) the contributions made from your paycheck will be taxed first then put into your Roth 401k.

You can contribute the same amounts as traditional 401ks and IRAs.

Benefits / Drawbacks of Roth 401k / Roth IRA

Since you’ve paid taxes up front, you won’t be paying taxes later down the road. If your tax bracket does increase you’ll benefit from investing in a Roth because you paid less taxes earlier.

Since you pay the taxes up front your money grows tax free and when you withdraw the money in retirement, you don’t have to pay taxes.

You can borrow the post-tax money you’ve invested in a Roth IRA without being assessed a 10% penalty as long as you are careful to borrow only the amount you put in, not any earnings it made. This could be good for a down payment on a first house. There are stipulations on this so be sure to check with your financial planner.

Anyone with a taxable income can open either account (for a Traditional IRA, you have to be younger than 70 and a half).

Contributions made to a Roth IRA are not tax-deductible because it is money you’ve already paid taxes on. If you are looking for tax deductions a Roth won’t help you out in that way.

You are not required to start taking money out by the age of 70 and a half with a Roth IRA. Since the government already has the taxes on your money they don’t care if you wait to start withdrawing it.

Withdrawing money from a Roth IRA before the age of 59 and a half also comes with a potential 10% early withdrawal penalty if you use the money for non-applicable expenses.

Quick Summary

401k: employer sponsored plan, contribute up to $18,000, pay taxes when you take the money out

IRA: Individual retirement account, contribute up to $5,500 if under 50, pay taxes when you take the money out

Roth 401k: employer sponsored plan, contribute up to $18,000, pay taxes before you contribute, grows tax free

Roth IRA: Individual retirement account, contribute up to $5,500 if under 50, pay taxes before you contribute, grows tax free


Which accounts will you invest in? Share in the comments below.



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