401(k) or Roth IRA? A Guide to Retirement Accounts

One of the biggest sources of confusion for clients is the difference in retirement investment options, and it's no surprise.  Determining the difference between an IRA and a 401(k) is confusing.  

Investing in your retirement is a smart move.  So smart, in fact, that the IRS has created different kinds of accounts to encourage you to invest by giving you tax advantages.  Each of these accounts has different tax advantages and limitations.  The types of accounts differ by whether you start one on your own or your employer starts it on your behalf, how much you can contribute in a year, and how the account is taxed.

Retirement Accounts You Might Find at Work:

Traditional 401(k)

This is a common option for larger companies and for-profit corporations.  You can often set up contributions to come right out of your paycheck, and your employer manages the account for you. You cannot start a 401(k) on your own; it must be done by an employer.  

Considerations: 

Employer Match - Employers often offer a "match" - they'll put money in if you do.  For example, in a 3% straight match, if you contribute 3% of your income, they will too. This means that for 3% of your pay you are putting 6% in your retirement account! It's like free money! We want to take advantage of free money whenever possible.  Talk with your HR department or plan administer to learn what your company offers.  

Vesting - Money you contribute to your retirement account is yours, and you can take it with you if you leave.  However, employers often require you to stay with the company for a certain period of time before you are able to access the money they contributed to your retirement account.  So, for instance, let's say you have $50,000 in your retirement account; you contributed half of it, and your employer matched the other half.  If your employer has a five year vesting period, you might need to stay with the company for five years until you can access the money they contributed on your behalf.  Talk with your HR department or plan administer to learn more.  

Taxes - You don't pay tax on the money you contribute in the year you put the money in, nor do you pay tax while the money stays in the retirement account.  When you withdraw the money, you will pay tax on the contributions (what you put in) and earnings (what you earned in the stock market) at your tax rate.  

Contribution Limits (as of 2017) - You can contribute up to $18,000 a year to a 401(k).  This can be helpful in making significant savings for retirement and also lowering your taxable income.  

403(b) 

403(b)s are very similar to 401(k)s (so see above).  The main difference is that 401(k)s are used in for-profit companies and 403(b)s are used in non-profit organizations. 

Simple IRA

Simple IRAs were created for small companies (less than 100 employees).  In many ways, they function very similarly to a 401(k) or 403(b).  

Employer Match - In a Simple IRA, employers must either match your contribution or make an unmatched contribution (they put money in whether or not you do).  

Vesting - Rules similar to a 401(k) may apply.  Talk with your plan administer to learn more.

Taxes:  You don't pay tax on the money you contribute in the year you put the money in, nor do you pay tax while the money stays in the retirement account.  When you withdraw the money, you will pay tax on the contributions (what you put in) and earnings (what you earned in the stock market) at your tax rate.  

Contribution Limits (as of 2017): You can contribute up to $12,500 a year and $15,500 if you're over the age of 50. 

Retirement Accounts You Start Yourself

  Individual Retirement Account (IRA) 

Your employer doesn't set up an IRA for you; they are individual accounts that you can set up on your own. It is also very common for people to roll a 401(k) to an IRA when they leave a job.  You can work with an investment advisor to start an IRA.  

Considerations: 

Employer Match and Vesting: Because your employer is not involved with this account, there is no employer match or vesting.  

Taxes:  In a Traditional IRA you don't pay tax on the money you contribute in the year you put the money in, nor do you pay tax while the money stays in the retirement account.  When you withdraw the money you will pay tax on the contributions (what you put in) and earnings (what you earned in the stock market) at your tax rate.  

Contributions to a traditional IRA may be tax deductible in the contribution year with current income tax due at withdrawal.  Withdrawals prior to age 59 1/2 may result in a 10% IRS penalty tax in addition to current income tax.  

Contribution Limits: You can contribute up to $5,500 a year to an IRA, $6,500 if you're over 50 years old.  

Roth IRA

The difference between a Traditional IRA and a Roth IRA is in how they are taxed.  Roth IRAs are also accounts you establish with an investment advisor, not through work, and it is possible to roll a 401(k) over to a Roth IRA (as long as you do it properly from a tax perspective).  The tax advantages Roth IRAs provide make them a very popular choice, particularly with people who have many years until retirement.  

Considerations: 

Employer Match and Vesting: Because your employer is not involved with this account, there is no employer match or vesting.  

Taxes:  In a Roth IRA you pay tax on the money you put into the account at your normal tax rate.  However, you do not pay tax on the money you put in or what you earn in the stock market while it accumulates or when you take the money out.

Said another way, the Roth IRA offers tax deferral on any earnings in the account.  Withdrawals from the account may be tax free as long as they are considered qualified.  Limitations and restrictions may apply.  Withdrawals before age 59 1/2 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax.  Of course, future tax laws can change at anytime and may impact the benefits of Roth IRAs.  Their tax treatment may change. 

Contribution Limits (as of 2017): You can contribute up to $5,500 a year to an IRA, $6,500 if you're over 50 years old.  

Still a little confused? We don't blame you; this can be tricky.  Get in touch with us, and we'd be happy to help you determine which account is best for you.  

Stephanie Vail

About the Author

Stephanie Vail is a member of the Custer Financial Advisors team.  She specializes in helping millennials with financial literacy and planning.  To learn more about Stephanie and Custer Financial Advisors, visit www.CusterFinancialAdvisors.Com or email Stephanie at SVail@lpl.com.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  For advice specific to your situation, please contact us.