So here the situation. You just started a new job straight out of college that offers a 401k and Roth 401k and you have no idea what the difference is or which is best for you. Or you are thinking about opening your own retirement account and aren’t sure what the difference between an IRA and Roth IRA. Well you are in luck, this blog will give you a run down on all the differences and similarities of each one of these. I will also give you examples of how each one can benefit you the most in a given socioeconomic situation. Lets get into it. And find out who is number one.
Side note: Do not focus on trying to save for retirement while you have large debts like student loan debt or large car payment or something along those lines. A mortgage does not qualify, it is perfectly fine to have a fix rate mortgage and focus most of your money on retirement. But focus on getting rid of bad debt first before going hard into retirement. You only have so much money and trying to pay off student loan debt and trying put 15% towards retirement will only slow your progress on both fronts.
401k and IRA: Lets start off with some history on the 401k since post people don’t talk about that very much. A 401k is a employee sponsored retirement plan. The reason it has a silly name and isn’t just called a employee retirement plan or something along those lines is because the tax code that was written for this retirement plan is 401k so they used that. But along with this new tax code that put the 401k in place, it also put into place individual retirement accounts (IRA) that are not tied to your employer. The 401k and its non-employer sponsored counter part, IRA have only been around for about 40 to 50 years, they were both first put into place in the tax code in the 1970s. Both allow you to put per-taxed money into an account and invest it into the stock market and have it grow tax free for a period of time. Since the money you are putting away is per-tax this lowers your tax burden lightly, meaning you play less in taxes throughout the year. The money you are putting in cannot be touched until you reach a minimum age to pull your money out at 59 1/2. Now at this point, you might wonder why does it must to be by then? Why can’t I just pull the money out before then? Well Congress didn’t think the masses could be trusted enough to know not to pull money from this retirement account so they made it so you will have to pay a 10% fee on any early withdraws. At 59 1/2 you can pull money out of that account and you will be taxed on it based on whatever tax bracket you are in at the time of taking the money out without any fees. For both the 401k and IRA accounts you need to aware of this since the money you are putting into this account is basically locked up till you are 59 1/2 unless you pay a 10%, with very few exceptions. Some of the exceptions are that you become legally disabled, laid off when you are 55 years ago, have medical expenses that exceed 7.5% of your adjusted gross income, or if you have a divorce and are court ordered to pay your spouse. None of these situations are desirable obviously. So for all intensive purposes just think that you are putting money away for 20, 30, or 40 years that you can’t touche. Another age to be aware of for these retirement accounts is age 70 1/2. Once you reach that age, you have to start pulling the money out. Another consideration for 70 1/2 is if whatever reason you decide at that very young age that now is the time to start saving for retirement using a IRA or 401k. Well… I am sorry to inform you that you cannot.
With that out of the way, lets talk about contribution limits for the IRA and 401k retirement plans. If you are just making tons and tons of money and want to put $50000 towards your retirement for the year, unfortunately that is impossible. For the 401k the maximum you can contribute in a year as of 2019 is $19000 and the maximum for the IRA is $6000 for people under age 50. If are you 50 or older you can contribute $25000 and $7000 to the 401k and IRA respectively, up to age 70 1/2. Now you financial wizards and math ninjas might be thinking to yourselves, “by god! what if I have two IRAs or two 401ks then I can double that contribution limit and be a billionaire wizard ninja.” I hate to be the barer of bad news but you can have two 401ks or IRAs but the limit of $19000 and $6000 will not change. You will just end up splitting your money and have a balance cut in half for your investments to compound on lowering your growth potential. That being said, there is nothing stopping you from having a 401k with your employer and have an IRA to effectively increase your contribution limit to $25000. That is pretty much all there is to 401ks and IRAs, lets get into the mysterious Roth accounts.
401k Roth and Roth IRA: The IRA and 401k were implemented in the 1970s, but in 1997, a senator from Delaware speared a new type of retirement account that came to be known as the Roth IRA. Named after him William Roth. Four years later in 2001, the Roth 401k was introduced as an employer sponsored retirement plan. Similar to the traditional 401k and IRA you put money into an account and invest that money into the stock market and there are similar contribution limits but that is about where the similarities end.
These Roth retirement accounts function quite differently, first and foremost is the money you are contributing is post-tax money and grow tax free period. There are no, I repeat no taxes that need to be paid by the time you start pulling money from the account at 59 1/2. Now the astute among you might be wondering, “well if its post tax money, then I won’t be taxed again for pulling it out before 59 1/2 right? oh but won’t I get hit with a 10% penalty for pulling money out early?” Not necessarily, the total amount of money that you have contributed to the account in post-tax money can be pulled out at any time with no fees or taxes. However, any amount of growth/earnings you have had in your money since investing it will be hit with taxes and a penalty if you were to withdraw that. For example, if you have put $10000 into either Roth retirement accounts and lets say you have had your money grow to $10500 after some period of time but you want to withdraw money for something and you pull $10000 out. That money is just yours, no taxes no penalty, you just pull it out like a saving account. However the second you go over that $10000 in withdraws then you will be taxed and are hit with a penalty on all the money that exceeded the $10000.
When it comes to contribution limits, these are identical to the traditional retirement accounts, $19000 and $6000 for Roth employee sponsored and Roth IRA respectively. Likewise, you can have both a Roth employee sponsored and a Roth IRA to increase your total allowable contributions each year and you can even mix and match between the traditional accounts and Roth accounts. You can have an employer sponsored 401k and a Roth IRA, or vice versa. The only difference here for the Roth is that you don’t have to start pulling money out of the account by age 70 1/2 and you can even open a Roth IRA after the age of 70 1/2.
What is right for you: So you just started a new job and these are the retirement plans they throw at you and maybe some benefits person quickly just said something along the lines of per-tax and post-tax and 401k something. They give you this very brief explanation that leaves you with more questions then answers and then they give you a deadline to make your decision by only a couple days or maybe even right there on the spot. But Luckily, you have read the explanation up above and have a good understanding of what each is and their features but you are still not sure what is best for you. Is it best to have the per-tax money maybe save a little on taxes or is it better to just be taxed now and put that money in place to grow tax free indefinitely? Well I am going to run through some situation where which account makes the most sense to do and when a mix is best. I am going to only focus on federal income tax in these scenarios since state income tax is so varied and in some states non-existent. I am also only doing single filing status to keep these examples simple and relatable as most people file as single, but these concepts are also universal for the most part. See Table 1 for a reference of federal income tax brackets. Keep in mind here that just because you make over $40000 a year, you won’t be taxed at 22% on the entire $40000. Only the the amount over $39475 will be taxed at 22%, then the amount from $9700 to $39474 is taxed at 12% and 0 to $9700 is taxes at 10%.
Employer Match: If your employer offers any kind of contribution match towards your 401k or Roth 401k ALWAYS ALWAYS TAKE IT! Contribute the minimum percentage to get the full match no matter your situation. This could mean a Roth IRA is best for you with your income bracket but your employer offers a 3% match lets say in a 401k. Take It! Always always take it! Then contribute to the Roth IRA as much as possible. This might sound like no duh to some people, but I had 37 year old co-worker who was contributing 0.5% to their 401k when our employer match up to 6%! It is literally free money! Always Take it! I cannot stress that enough.
Scenario One: You make about $35000 a year and you are new to the workforce and presumably will be making more later in life. In this scenario you are basically in the lowest income tax bracket possible but at the same time you make enough to likely have an employer that offers a retirement. At your income, you would be taxed at 12%. And lets say your employer offers both a traditional 401k and a Roth version, which do you choose? Well you should go for the Roth, the taxes you are paying now will pretty likely be less than when you retire. Another reason to do this is because no one knows what tax rates will be in the future, the taxes rates could very well be higher so taking advantage of this incredibly low income tax will insulate you from paying more in the future. In my opinion, I think taxes will without a doubt be higher in 30 years time. So if this was me in this situation I would definitely go for the Roth. But again, no one knows for sure, that’s just my thoughts on the matter. Regardless of future tax rates, just going off of the 2019 brackets you are paying almost as little income tax as possible so you may as well take advantage of that. Later on in your career if you get into a high income tax bracket then considering a traditional IRA would be a good idea. But we will get more into that in later scenarios
However, another variation of this scenario is maybe your employer only offers a traditional 401k. So in this situation take the 401k and put like 1% or 2% towards it but put the loin’s-share of your retirement money into a Roth IRA for the same reasons as stated above. This way are taking advantage of that awesome income take rate of 12% and you have a 401k set up for potentially utilizing later in your career.
Scenario Two: You are someone who is in their early to mid-career making about $45000 a year. So your income tax would be 22%, 10% more than scenario one, that’s quite a significant increase in tax burden. So if you notice, your income is only a little bit higher than the threshold between 12% and 22%, you are only about $5600 over the line. So in a situations where you can lower your taxable income enough to duck under into a lower taxes bracket is where you want to take that traditional employer 401k or IRA and calculate how much you would need to put away each month to break into that 12% bracket. In this example, it would be about 12.44% of your income but lets just say 12.5% since most retirement accounts only allow for half percent increments. So that would just barely put you into the 12% bracket, lowering your tax burden significantly, this is a monumental difference. With the much lower tax burden you may even have enough extra money laying around to put a small amount (1% to 2% or more) towards a Roth IRA at again that sweet, sweet 12% income tax level. If you are someone in a situation similar to this where you can lower yourself to the 12% income bracket, absolutely do it! If your income is around this amount and you end up staying at that position for a few years you will be killing it. Plus, if you are in your mid to late 20s or early 30s doing this, you will be a millionaire come retirement without question.
Scenario Three: You are someone who is single and in their early to mid-career making about $60000 a year. So your income tax is 22% and getting that down low enough to break into the 12% bracket is all but impossible. So there is no clear answer here, but I recommend you ask yourself where you want to be at retirement. Do think you will be making more than $60000 when you retire or will be making less? This scenario applies to me. So for me, I plan to be making more by the time I reach retirement age and plan to have other sources of income like rentals and dividend stocks. So in this case I would recommend the Roth IRA or Roth 401k if your employer offers it. The reason being, is again we do not know what the tax brackets will look like 20 to 30 years. Also, regardless of that if my income is higher that would more than likely lead to an increase in taxes. So I plan to hedge my bets on this income tax bracket and let my invests grown unabated for 30 years and have no other taxes I can be hit with in the future. And if I ever run into a situation where I need a lot of money out of nowhere I can take from this account without having to pay any taxes or penalty on the principal balance. Ideally, you would also have an emergency fun of about 6 months worth of expenses to cover any unforeseen emergencies, but if you don’t or are in the process of building one when something happens at least you can cover it if all unless fails. That being said, I recommend you have at least $1000 in an emergency fund just to be safe before you do anything related to saving for retirement or paying off student loans.
However, if you are someone who thinks they will be making less than what you are now. Then going with the 401k is probably the better option, since you will be in a lower tax bracket and will have potentially dodged 10% (assuming 2019 tax brackets) worth of income tax on a sum of money in the hundreds of thousands or even millions. But again there is no guarantee that will be the case. Either way, if you think the 401k or Roth 401k is better no matter the path you take as long as you are saving 15 to 20% of your income you will be set for retirement. And again you can always put money toward a mix of accounts to hedge your bets that way.
Scenario Four: When you break into the 24% income bracket, things become less drastic in terms of lowing your tax percentage, since the most you could possibly lower it is to 22% if any at all. However, you need to start more seriously consider that you might not be making more than what you are currently when you retire. So if you are making lets say $102000 a year. You could probably put enough towards a traditional employer sponsored retirement with that level of income to still drop you into the 22% bracket, which you should definitely do. Its not nearly as significant as dropping 10% as before but who in the world would want to pay more in taxes if you don’t have to. Likewise, even with a uncertain tax bracket future making more than this a year while retired would be difficult to do, not impossible by anymore but much less likely for most people even with other sources of income. So focusing on maxing out your 401k each year should be more first priority, then max out your IRA. Maybe having a Roth IRA instead of a traditional IRA would be a good idea just to have a nice mix of tax deferred money sources.
If you are making significantly more than this a year, most likely going all traditional would be the best bet, unless you are just setting up an empire of other income sources that would keep you at this tax bracket or take you to even crazier heights. In that case, the Roth would be the best option.
Scenario Five: If you are in the 32% tax bracket or up, all the principles laid out in the previous scenarios apply, however the 401k become more and more likely to be your best friend since making much more than that while retired becomes less and less likely. And any change in the tax brackets are likely to be inconsequential if you go from making $250000 a year to $150000 in retirement. When picking a retirement plan, it can really be boiled down to: Do you think you will be making more in the future? If so, Roth is your friend. If not, then 401k all the way.
Who is Number One: Smitty Werbenjagermanjensen. He was number one!
TL;DR: A 401k is an employer sponsored per-tax money retirement account with a limit of $19000 per year. Roth is the same thing just post-tax money. IRA stands for individual retirement account, not the Irish Republican Army. Roth IRA however, does stand for Roth’s Irish Republican Army and they only accept post-tax money for their war effort with a limit of $6000 a year just like the regular IRA. For the love of Plutus (Greek god of wealth) take the damn employer match! Its free money damn it! If you make less than $39475 go with a Roth account without a doubt. If you make more than that: Ask yourself if you think you will be making more or less in retirement? If yes, Roth is your guy. If no, the 401k and the traditional Irish Republican Army is for you. Smitty Werbenjagermanjensen. He was number one!
The Millennial 
This is so good!
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