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Which retirement account is right for you?

Quick Summary

  • 401(k)s, traditional IRAs, and Roth IRAs are tax-advantaged ways to save for retirement.
  • While similar, there are features that make each a unique way to save.
  • It’s possible to contribute to all three accounts, but income and contribution limits apply.

In the past, many people relied on a company pension and Social Security to provide for their retirement plans. You worked for a long time, retired, and then lived off those two sources of income.

Today, however, pensions have all but disappeared. And the thought of relying on Social Security alone might make you nervous. So, it’s up to you to take charge of your own savings to secure a comfortable retirement.

Of course, there are many choices when it comes to retirement accounts. The decisions can be confusing, if not overwhelming.

Important: You can contribute to more than one type of retirement account.

To help you get started, here’s a look at three of the most popular retirement savings accounts: 401(k)s, traditional IRAs, and Roth IRAs.

A jar full of money to invest in retirement plans.

What Is a 401(k) Plan?

An employer-sponsored 401(k) may be the best-known retirement savings account simply because so many people encounter them at work. With 401(k)s:

  • Contributions are taken off the top of your gross income, reducing your income tax bill for that year.
  • Your funds grow tax-deferred.
  • You pay taxes when funds are distributed from the account.
  • Required minimin distributions start at age 70 1/2.

Of the “big three” retirement plans—401(k)s, traditional IRAs, and Roth IRAs—the 401(k) offers the highest annual contribution limit. For 2019, the limit is $19,000 a year, plus an additional $6,000 if you’re age 50 or older.

Your 401(k) contributions are made with pre-tax dollars. They reduce the amount of your gross income, which saves on taxes in the year you contribute to the 401(k). Your contributions and earnings grow tax-free within the account, too. You’ll pay taxes when you withdraw the money in retirement.

Some companies offer a Roth version of the 401(k) plan. In that case, you’ll pay tax on your contributions when you make them. Then, in retirement, you can withdraw your contributions and earnings tax-free. Any employer contributions, however, are still taxed when you withdraw them.

Fast Fact: 91%. The percentage of workers with 401(k) plans who say that payroll deductions help them save. 

401(k) Employer Matches

The biggest 401(k) perk is the employer match—if your company offers one. Many companies match a certain percentage of employee contributions, up to a capped amount.

Here’s an example. Say your employer matches 50% of your contributions, up to 5% of your salary. If you earn $60,000 a year, you’ll invest $3,000 per year (5%) and the company will add an additional $1,500 (50% of that 5%) into your account. A company match is essentially free money that provides an automatic 50% return on your contributions.

However, there are some downsides. It’s your account, but the company owns the plan and chooses an administrator to offer different mutual funds within it. So, you have limited choices when it comes to investment options.

You also incur management and administrative fees, along with investment fees that are hidden deep within the fine print of the financial statement. And there’s not much you can do about it unless you choose not to participate in the plan.

What Is a Traditional IRA?

IRA stands for Individual Retirement Account. The traditional IRA is similar to the 401(k) in that:

  • You may be able to deduct your contributions the year you make them.
  • Contributions and earnings grow tax-deferred.
  • You pay taxes when you withdraw money during retirement.
  • Required minimin distributions start at age 70 1/2.

An IRA is held entirely by you. Your company doesn’t own it, and your company won’t offer you a match on your investments. Since you own the account, you get to choose where it’s held—your local bank, a major brokerage firm like Charles Schwab, or a mutual fund company like Vanguard.

Because you choose the firm and the investments, it’s easier to see how much you’re paying in management fees and fund expense ratios.

Traditional IRA Limits

For 2019, you can invest $6,000 in a traditional IRA, or $7,000 you’re age 50 or over. Also, the amount you can deduct may be limited if you or your spouse (if you’re married) are covered by a retirement plan at work and your income exceeds certain levels. Here’s a rundown for 2019:

2019 Traditional IRA Deduction Limits
If your filing status is… And your modified AGI is… Then you can take…
Single, head of household, qualifying widow(er), married filing jointly or separately and neither spouse is covered by a plan at work Any amount A full deduction up to the amount of your contribution limit
Married filing jointly or qualifying widow(er) and you’re covered by a plan at work $103,000 or less A full deduction up to the amount of your contribution limit
More than $103,000 but less than $123,000 A partial deduction
$123,000 or more No deduction
Married filing jointly and your spouse is covered by a plan at work $193,000 or less A full deduction up to the amount of your contribution limit
More than $193,000 but less than $203,000 A partial deduction
$203,000 or more No deduction
Single or head of household and you’re covered by a plan at work $64,000 or less A full deduction up to the amount of your contribution limit
More than $64,000 but less than $74,000 A partial deduction
$74,000 or more No deduction
Married filing separately and either spouse is covered by a plan at work Less than $10,000 A partial deduction
$10,000 or more No deduction

What Is a Roth IRA?

Roth IRAs are the newest kids on the retirement-plans block. They share many similarities with traditional IRAs in that you own the account, choose the investments, and you can see the fees you pay. They also share the same contribution limits. For 2019, you can contribute up to $6,000 to a traditional or Roth IRA, or $7,000 if you’re age 50 or older.

But Roth IRAs have features that are different than 401(k)s and traditional IRAs:

  • You pay your taxes upfront, and then qualified distributions in retirement are tax-free.
  • You can withdraw your contributions at any time, for any reason.
  • There are no required minimum distributions during your lifetime.

The biggest difference between a traditional IRA and a Roth, however, is when you pay your taxes. Unlike a traditional IRA, you don’t get an upfront tax break with a Roth IRA. You invest with after-tax money, so you pay tax when you make a contribution.

Your contributions and earnings grow tax-free. And you can withdraw your contributions any time, for any reason, without owing taxes or penalties. The best part: Qualified distributions—those taken when you’re age 59 1/2 or older and when the account is at least five years old—are tax-free, whether you withdraw contributions or earnings.

This can be a huge advantage if you expect to be in a higher tax bracket during retirement than you are now. And unlike traditional IRAs, there are no required minimum distributions during your lifetime. That means you can leave the money alone if you don’t need it, and pass it on to your heirs—tax-free.

Roth IRA Limits

There are income limitations with Roths, but they work differently than they do with traditional IRAs. You can contribute to a traditional IRA regardless of income. But, if you or your spouse are covered by a retirement plan at work or make too much money, your deductions will be limited.

With a Roth IRA, on the other hand, the amount you can contribute may be limited by your filing status and modified adjusted gross income. Here’s a rundown for 2019:

Roth IRA Contribution Limits
If your filing status is… And your modified AGI is… You can contribute…
Married filing jointly or qualifying widow(er) Less than $193,000 Up to the limit
More than $193,000 but less than $203,000 A reduced amount
$203,000 or more Zero
Married filing separately and you lived with your spouse at any time during the year Less than $10,000 A reduced amount
$10,000 or more Zero
Single, head of household, or married filing separately and you didn’t live with your spouse at any time during the year Less than $122,000 Up to the limit
More than $122,000 but less than $137,000 A reduced amount
More than $137,000 Zero

You Can Invest in a 401(k) and an IRA

How do you decide which of the “big three” retirement plans works best for you? Here are some tips:

  • If you expect your income tax rate to be higher in the future, a Roth IRA—or a Roth 401(k)—could be a good choice. That way, you pay taxes today, while you’re in a lower tax bracket. And qualified distributions are tax-free during retirement. If you don’t need the money, you can leave it in the account. There are no RMDs with Roths.
  • If you expect your income tax rate to drop in retirement, a traditional IRA or 401(k) makes the most sense. You’ll get a tax break now when you make contributions. And you’ll pay taxes on withdrawals when you’re in a lower tax bracket.  But watch out: You must start taking RMDs at age 70 ½, and that will increase your taxable income for the year.
  • If you have the resources to do so, it can be a good idea to invest in a 401(k) and an IRA. You can make a full contribution to a 401(k) even if you fund an IRA. But for IRAs, you can contribute up to the limit for all your IRAs combined. So, if you have a traditional and a Roth IRA, you could contribute $3,000 to each (for a total of $6,000)—but not $6,000 to each.
  • If have you an employer match, take advantage of it (it’s free money). Max out your 401(k) contribution to get the match first, then try to max out your Roth.

Wherever you decide to stash your retirement savings, start early. In all these accounts, your contributions and earnings grow tax-free. The more time you have until retirement, the longer your money can work for you. And that puts you one step closer to a secure and comfortable retirement.  

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