When it comes to investing for retirement, there are multiple tax-advantaged accounts to choose from. It can be confusing to pick which one is best, especially when they each have their own pros and cons.
To help you out, three Motley Fool retirement experts each made the case for one of three common types of retirement accounts: 401(k)s, traditional IRAs, and Roth IRAs. Check out the arguments for each and see which one seems like the best fit to meet your needs.
Katie Brockman: The 401(k) is a type of employer-sponsored retirement account. When you invest in a 401(k), you get a tax deduction on your contributions upfront, and your investments grow tax-free. Once you retire and start taking distributions, then you will owe income taxes on your withdrawals.
The 401(k) can be an incredibly powerful investing tool, and there are several advantages to investing in this type of account.
For one, you may be entitled to receive employer matching contributions. Not all 401(k) plans offer matching contributions, but if you do have access to them, it’s wise to take full advantage of this perk. Matching contributions are essentially free money, and they can boost your savings by thousands of dollars per year with zero effort on your part.
For example, say you’re earning $50,000 per year, and your employer will match your contributions up to 3% of your salary. That amounts to $1,500 per year in matching contributions. If you were earning an 8% annual rate of return on your investments, that $1,500 per year could add up to close to $170,000 in savings over 30 years.
Keep in mind, too, that this $170,000 is just in matching contributions alone. Once you factor in your own contributions, you’ll have at least twice that amount saved. In addition, your salary is likely to increase as you age. If your employer is matching a certain percentage of your salary, that also means you’ll be entitled to more money in matching contributions with every raise.
Another advantage of investing in a 401(k) is that it’s easier to save consistently. Many 401(k) plans allow you to divert a set amount of money from each paycheck directly to your retirement account. When the money never reaches your bank account in the first place, it’s less tempting to spend it before you can save it.
Finally, 401(k)s have higher contribution limits than IRAs. As of 2021, you can contribute up to $19,500 per year to your 401(k), compared to just $6,000 per year to your IRA. If you’re age 50 or older, you can also contribute an additional $6,500 per year to your 401(k), as opposed to an extra $1,000 per year with an IRA. Not everyone will be able to max out their 401(k), of course. But if you’re a super-saver, the higher contribution limits can help your money reach its full potential.
First, let’s get the drawbacks out of the way. IRAs have lower annual contribution limits than 401(k)s. Currently, they max out at $6,000 for workers under the age of 50 and $7,000 for workers 50 and over. On the other hand, 401(k)s max out at $19,500 for workers under 50 and $26,000 for those 50 and over, so there’s a greater opportunity there to sock away more funds for the future. Also, traditional IRA withdrawals are taxable in retirement, and IRAs are subject to required minimum distributions.
But in spite of that, traditional IRAs are a valuable retirement savings tool for a number of reasons. First, the money you put into a traditional IRA serves as an instant tax break. Say you’re in the 24% tax bracket based on your income and filing status, and you put $6,000 into your IRA this year. That means the IRS won’t tax you on $6,000 of earnings, so all told, you’ll shave $1,440 off of your 2021 tax bill.
Secondly, IRAs offer a wide range of investment choices — far more options than what you’ll usually see with a 401(k). With the latter, you’ll generally be limited to a couple of dozen funds, some of which can charge very high fees that eat away at your returns. Traditional IRAs, on the other hand, let you invest in individual stocks, which means you can customize your retirement portfolio to suit your needs, investing strategy, and goals, all the while avoiding some of the costly fees 401(k)s are notorious for.
Finally, traditional IRAs give you a fair amount of flexibility with your money. You can take a withdrawal from an IRA penalty-free to cover the cost of higher education, and you can also withdraw up to $10,000 without penalty for a first-time home. And while it’s generally a good idea to reserve your IRA funds for retirement, it’s also nice to have options.
All of these perks make a very strong case for saving for retirement in a traditional IRA. Best of all, you can open an IRA independently, so if your employer doesn’t offer a retirement savings plan, you can still take savings matters into your own hands.
But Roth IRAs work differently than either of the other two other accounts on this list. Unlike with a 401(k) or traditional IRA, contributions to a Roth IRA aren’t deductible in the year you make them. Instead, you contribute with after-tax dollars but withdraw money tax-free as a retiree.
If you expect you’ll be in a higher tax bracket later in life than you are now, a Roth IRA is the way to go. You’ll benefit from being able to withdraw money from your retirement accounts without worrying about the IRS taking a cut.
There’s also another perk to think about when it comes to your tax bill. Social Security benefits can become taxable if your income is high enough. But distributions from a Roth IRA don’t count toward determining that income. That means you could potentially avoid taxes on all of the income you live on as a retiree if you opt for a Roth IRA.
You also have more flexibility regarding when you take money out of your Roth IRA. While required minimum distributions are mandated from traditional 401(k) and IRA accounts after age 72, the government won’t make you take money out of your Roth IRA or risk a penalty equaling 50% of the amount you should’ve withdrawn.
If you don’t want to worry about taxes as a retiree or take money out on a schedule determined for you, a Roth IRA is the way to go.