What is a Traditional IRA, Roth IRA, 401(k), and Roth 401(k) ?
A Traditional IRA, Roth IRA, 401(k), and Roth 401(k) are all types of retirement savings account that people can use to save money for their future. These accounts have specific rules about when and how much you can contribute, as well as when and how you can withdraw your money. Each type of account also has its own tax advantages and disadvantages, which can affect how much money you’ll have available for retirement. Understanding the differences between these accounts can help you make informed decisions about your retirement savings strategy.
Traditional IRA: A Traditional IRA allows individuals to make contributions with pre-tax dollars, which reduces their taxable income in the year the contribution is made. The contributions and any investment earnings grow tax-deferred until they are withdrawn, at which point they are taxed as ordinary income. Withdrawals from a Traditional IRA before age 59.5 may be subject to an early withdrawal penalty, as well as taxes.
Roth IRA: A Roth IRA allows individuals to make contributions with after-tax dollars, meaning the contributions are not deductible from their taxable income. However, the contributions of any investment earnings grow tax-free and withdrawals in retirement are also tax-free, as long as the account has been open for at least 5 years and the individual is over age 59.5. There is no early withdrawal penalty for Roth IRAs.
401(k): A 401(k) is a type of employer-sponsored retirement savings plan. Employees can contribute to their 401(k) with pre-tax dollars, reducing their taxable income, and the contributions and investment earnings grow tax-deferred until they are withdrawn. Withdrawals from a 401(k) before age 59.5 may be subject to an early withdrawal penalty, as well as taxes. Some 401(k) plans also offer a matching contribution from the employer, providing an additional incentive for employees to save.
Roth 401(k): A Roth 401(k) is similar to a Traditional 401(k), but allows individuals to make contributions with after-tax dollars. The contributions and investment earnings grow tax-free, and withdrawals in retirement are also tax-free, as long as the account has been open for at least 5 years and the individual is over age 59.5. There is no early withdrawal penalty for 401(k)s.
In the graphic above, you can see the breakdown of each type of retirement program. However, please note that the contributions limits were as of 2016. Imaged sourced from here.
Here are some similarities and differences between these retirement savings options:
Similarities:
All of these options offer a tax-advantaged way to save for retirement.
All of them have contribution limits.
All of them have rules around early withdrawals, including penalties and taxes.
Differences:
Traditional IRA vs Roth IRA: The main difference between an IRA and a Roth IRA is the way they are taxed. Contributions to a Traditional IRA are tax-deductible in the year they are made, but withdrawals in retirement are taxed as ordinary income. On the other hand, contributions to a Roth IRA are made with after-tax dollars, but withdrawals in retirement are tax-free.
401(k) vs Roth 401(k): The main difference between a 401(k) and a Roth 401(k) is also the way they are taxed. Contributions to a 401(k) are made with pre-tax dollars and are taxed as ordinary income when withdrawn in retirement. Contributions to a Roth 401(k) are made with after-tax dollars and withdrawals in retirement are tax-free.
Traditional IRA vs 401(k): The main difference between an IRA and a 401(k) is their sponsorship. IRAs are personal retirement savings accounts that can be opened by anyone, while 401(k)s are sponsored by an employer. Employer-sponsored 401(k)s usually offer more generous contribution limits and may include matching contributions from the employer.
Roth IRA vs Roth 401(k): The main difference between a Roth IRA and a Roth 401(k) is their sponsorship and contribution limits. A Roth IRA is a personal retirement savings account with lower contribution limits, while a Roth 401(k) is sponsored by an employer with higher contribution limits.
In summary, a Traditional IRA and a Roth IRA are like a piggy bank that individuals put money into to save for when they’re older. The main difference is when they have to pay taxes on them. While a 401(k) and Roth 401(k) are a special kind of savings account that individuals use if they have a job (employee-sponsored). The main difference between these two are when they have to pay taxes on them similarly to that of a Traditional IRA and a Roth IRA. A Traditional IRA and a 401(k) are both pre-tax dollars, while a Roth IRA and Roth 401(k) are both after-tax dollars.
It’s important to consider factors such as income, tax bracket, and retirement goals when deciding which type of IRA or retirement savings plan is right for you. A financial advisor can help you evaluate your options and determine the best course of action.
