Retirement Funds: What’s the Difference?

Whether you’re a Wall Street Banker or the night janitor at Walmart, having a retirement plan in place is essential for ensuring your financial future. If you haven’t created a plan yet, doing so as soon as possible is the first step toward locking in security come retirement. And there are different types of retirement funds from which to choose.

However, saving for retirement is more than throwing your money into a bank account and calling it a day. Various types of retirement accounts offer a myriad of benefits for every situation, from employer contributions to higher return on investment. That’s why choosing the right account for your situation is essential to your future security.

First, though, you have to know your options for retirement funds.

TL;DR

There are several retirement funds available today, with the most common being 401(k)s, IRAs, and the Roth variations of each. Each of these funds has its own limitations, tax rules, and benefits, which means it’s up to you to decide which account works best for your situation.

  • 401(k)s are employer-sponsored accounts. You make contributions into a 401(k) are pre-tax, which means you pay income tax come retirement. The current IRS contribution cap is set at $19,500 for individuals under 50 and $26,000 for those over 50. These are often good for those who believe they will be in a lower income tax bracket come retirement.
  • Roth 401(k)s are similar to a 401(k), with two major changes: employers cannot contribute to these accounts; and you deposit funds post-tax. This means that the government does not tax qualified withdrawals upon retirement.
  • IRAs, or individual retirement accounts, are tax-advantaged retirement plans for individuals. Similar to a traditional 401(k), contributions made into a traditional IRA are pre-tax and tax-deductible on your annual return. The current combined contribution cap for both traditional and Roth IRAs is $6,000.
  • Roth IRAs work similarly to a Roth 401(k). You deposit funds post-tax, and you can make withdrawals equivalent or less than your usual contribution amount at any time with no tax or penalty after owning the account for five years. With a Roth IRA, however, you can’t take a tax deduction on contributions the year you make them.

What Types of Retirement Funds Are There?

There are several types of retirement accounts available through employers and to individuals today. Some cater to specific classes of income, while others are solely available to nonprofit employees or public service workers. Due to the variety, many individuals maintain multiple retirement accounts to fully capitalize on their savings potential.

Some of the most common types of retirement accounts include:

  • 401(k) and related accounts
  • Roth 401(k)s
  • IRA variants
  • Roth IRAs

Each of these has its limitations, benefits, and tax consequences, depending on when you make contributions and withdrawals. Let’s start by examining the difference between a 401(k) and a Roth 401(k).

401(k)s

401(k)s – and their more selective variants 403(b)s and 457(b)s – are a type of defined contribution plan. These accounts are tax-advantaged, which means that they have special tax benefits or deferral options.

Because 401(k)s are employer-sponsored accounts, both the employer and employee can contribute funds. The IRS caps the exact dollar amount, with the amount changing yearly to account for inflation.

In 2020, the IRS set annual employee contribution limits at:

  • $19,500 for workers under 50
  • $26,000 for workers over 50

For combined employee-employer contributions, or for employees who invest beyond the maximum tax deduction, the IRS set the limit at $57,000 (or $63,500 over 50). While the government does not require employers to match contributions, many include 401(k) matching in their employee benefits package.

With any type of 401(k), it’s still up to the employees to select specific investments under their plan. However, the sponsoring company handpicks these investments first, which can limit your options. Most companies offer an assortment of securities, such as mutual funds, target-date funds, and even company stock in their benefits packages.

Traditional vs Roth 401(k)s

There are two main types of 401(k)s: traditional and Roth accounts. The primary difference between these retirement funds has to do with taxes.

With a traditional 401(k), an employee deposits pre-tax funds into the account. The employee can then write this amount off on their tax return, which lowers their adjusted gross income for the year and may even push them into a lower tax bracket.

However, when it comes time to take a withdrawal, the government levies income taxes at the employee’s current tax bracket on every paycheck. This income tax also applies to any interest earned in the account.

On the other hand, employees who use a Roth 401(k) deposit funds post-tax, which means that qualified withdrawals – and the interest earned on the account – come out tax-free come retirement. However, because the individual pays taxes before contributing toward the account, these funds can’t be written off on a tax return.

An employee may utilize both types of accounts to capitalize on their benefits. However, only employees may contribute to a Roth 401(k), whereas employers can also contribute to a traditional 401(k). Furthermore, contributions to both accounts cannot exceed the annual limit set by the IRS. (As a reminder, that amount is $19,500 in 2020).

Withdrawals

Withdrawal requirements for 401(k)s are fairly strict to ensure the money stays put until you need it (and the federal government gets their cut). Those who don’t meet special criteria – such as a permanent disability – will be charged a 10% early-withdrawal penalty on top of applicable taxes for removing funds before the age of 59½. 

Furthermore, both traditional and Roth 401(k)s have RMDs, or required minimum distributions. This means that, beginning at age 72 (as of 2020), the account holder must take out a minimum payment from their 401(k), whether or not they need or want the money.

Individuals who still work for the company holding their 401(k) are exempt from RMDs. Additionally, you can avoid RMDs by rolling your account into a Roth IRA, although there are restrictions, fees, and legal concerns that come with this move.

Which 401(k) Plan is Better?

Generally speaking, a Roth 401(k) is best for workers who expect to be in a higher tax bracket come retirement. This allows individuals to avoid paying higher income taxes on withdrawals. Young workers and those making their way up a corporate ladder fall into this category.

Conversely, those who may be in a lower tax bracket come retirement may see more benefits from a traditional 401(k). This allows them to take a tax break on their income now and pay lower income taxes on withdrawals later.

It’s also worth noting that 401(k) contributions are invested into various funds to grow, but the interest earned and withdrawn in a Roth won’t be taxed. However, with a traditional 401(k) account, any interest on invested funds is subject to the same income tax as the original contributions. This means that investing in a Roth 401(k) at a young age can be more valuable over time than investing in solely a traditional 401(k).

IRAs

IRAs, or Individual Retirement Accounts, are a type of fund created by the U.S. government to help individuals, freelancers, and sole employers to save for retirement. Similar to their 401(k) counterparts, they are tax-advantaged and have limited annual contributions. Furthermore, traditional IRAs and Roth IRAs follow a similar pattern to traditional and Roth 401(k)s.

However, IRAs also offer some flexibility over 401(k)s, as an individual’s employer doesn’t get to call the shots. That being said, because these are individual accounts, employers also can’t contribute – which places the burden to save and invest for retirement solely on the individual’s shoulders.

Let’s explore these options in more depth. 

Types of IRAs

There are several types of IRA plans, including:

  • Traditional IRAs – tax-advantaged, diversified accounts
  • Roth IRAs – post-tax accounts
  • Spousal IRAs – retirement accounts for spouses
  • Rollover IRAs – accounts with funds rolled over from other IRAs or 401(k)s
  • SEP (Simplified Employee Pension) IRAs – built for small business owners
  • SIMPLE (Savings Incentive Match for Employees) IRAs – similar to a 401(k) from an employee standpoint

We’ll cover the first two of these in depth, since they’re the most common.

Traditional vs Roth IRAs

There are two main types of IRAs: traditional IRAs and Roth IRAs.

With a traditional IRA, contributions are tax-deductible for both state and federal taxes in the year contributions are made. However, like a traditional 401(k), this means that withdrawals are taxed at your current income rate come retirement.

The major benefit with these tax deductions is that such contributions actually lower your taxable income the year you make them. This can lead to other tax breaks as a result of moving your income into a lower tax bracket.

On the other hand, with a Roth IRA, you don’t get to claim contributions as tax deductions the year you make them. This also means that you don’t get to lower your adjusted gross income, which may leave you high and dry in a more expensive tax bracket.

However, this also means that qualified withdrawals in retirement are tax-free, as you paid the tax man by not deducting the contributions from your income.

Similar to a 401(k), traditional IRAs levy a 10% penalty on top of taxes if you pull out funds before 59 ½ years of age. However, there are some special circumstances in which the 10% fee may be waived. Such provisions include paying for college, making a down payment on your first house, or becoming disabled.

With a Roth IRA, on the other hand, you can withdraw funds at any time both tax- and penalty-free as you need them as long as you’ve had the account for at least five years. The one catch to avoid these penalties is that you can’t withdraw sums larger than your typical contribution. Doing so puts you at risk of having to pay various fees.

IRA Limitations

With a traditional IRA, you can contribute up to $6,000 as long as you’re younger than 70 ½ years of age, regardless of your tax bracket. While tax deduction eligibility depends on your overall income and if you invest in multiple retirement plans, the ability to tuck away funds regardless of your income is a nice feature.

Roth IRAs, on the other hand, have both income and contribution eligibility limits. In 2020, a single filer may contribute to a Roth IRA only if they make an adjusted gross income of less than $139,000 per year ($206,000 for joint filers).

Like a traditional IRA, the maximum contribution limit is set at $6,000 ($7,000 for filers over 50 years of age). Furthermore, the more money you make, the less you’re allowed to contribute.

If you choose to use both a traditional and Roth IRA, it’s important to note that contributions made to either account count toward the $6,000 maximum. That is to say, the combined maximum for IRAs is $6,000.

Withdrawals

With a traditional IRA, RMDs (Required Minimum Distributions) are mandatory, taxable withdrawals automatically paid out once you hit 70 ½ years of age. The percentage you’re required to take is based on age and the amount of money you have stashed away. These RMDs are paid regardless of whether you want or need the income.

Roth IRAs, on the other hand, have no RMDs, which makes them excellent wealth-transfer vehicles. However, if your Roth IRA rolls over to a beneficiary after your death, they are required to take distributions or roll the money into a new account.

Which IRA Plan is Best?

Just like with a 401(k), the best IRA for you depends on your current and future financial status. If you think you’ll be in a higher tax bracket come retirement, a Roth IRA will allow you to pay taxes now and skip payments on withdrawal. This can potentially save you thousands.

On the other hand, if you believe you’ll be in a lower tax bracket when you retire, a traditional IRA will allow you to pay less in income taxes on your withdrawals then than you would pay for Roth contributions now.

What is the Difference Between These Funds?

Both 401(k)s and IRAs allow the middle class and below a chance to save for retirement in tax-advantaged accounts. Furthermore, current IRS rules allow you to contribute to both at the same time, although there may be some strings attached if you’re outside of certain income brackets.

The biggest difference between these types of accounts is where they originate and how much you can contribute. 401(k)s are specifically employer-sponsored accounts, whereas IRAs are the sole responsibility of individuals.

Employer-sponsored accounts have much bigger contribution limits compared to IRAs. Additionally, many employers match contributions, which means that you’re earning extra income toward your retirement without the temptation of those funds showing up on your paycheck. (In other words, you and your employer share the burden of investing in your future plans).

These accounts also differ in your options. With a 401(k), your investment options are limited based on which accounts your employer prefers. With an IRA, on the other hand, you can choose almost limitless investment options to suit your needs.

Which is Right for Me?

Generally speaking, financial advisors recommend that individuals who receive a company match into their 401(k) max out these contributions first.

For instance, if your employer offers a 100% match up to 3% of your salary, you should contribute that maximum 3%. Get the most from your employer. Once your match is maxed out, focus on maxing out Roth IRA contributions for the year (assuming you qualify).

Then, after you’ve paid $6,000 into your IRA, you can pay into your 401(k) for the rest of the year. (Or until your contributions are maxed out per the IRS.)

However, if your company doesn’t offer a match, advisors typically recommend that you skip the 401(k) initially. Instead, focus on either an IRA or Roth IRA. This will allow you a broader choice of investments while minimizing your administration fees.

After you’ve funded the account up to the limit, tuck away any extra funds for the year in your 401(k). Even without the company match, there’s no reason not to enjoy the tax benefits on your hard-earned money.

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