Roth IRA, Traditional IRA, 401k… Are you totally confused by all these terms and acronyms? Read this article for a super beginner-friendly explanation of how these accounts work and their differences, pros & cons.

So let’s get right into it. All 3 of these accounts are designed to help you save for retirement. That means they come with restrictions on when you can withdraw the money (so typically you have to wait ’til you’re 59.5 to start spending it), but they also come with AMAZING tax benefits. If you don’t take advantage of the huge tax breaks you get from having these accounts, you’re leaving tens of thousands of dollars on the table!

What is the IRA?

IRA-  stands for Individual Retirement Account. Back in the day, the Traditional IRA was the only type of IRA – hence the name Traditional. The Roth IRA is a much newer option that came around several decades later in 19XX, thanks to a senator named X Roth – hence the name Roth IRA!

Since the Traditional IRA came first, I’ll start by explaining that one. Traditional IRAs are investment accounts that give you special tax benefits that you don’t get with non-retirement investment accounts. When you contribute to a Traditional IRA, it immediately reduces your taxable income. So if you contribute $6k to your Traditional IRA (which is the maximum allowed contribution in 2019), then you reduce your taxable income by $6k. That’s huge! That’s 30-40% on $6k that you DON’T have to pay in taxes. Do you know how you get a tax break when you donate to charity? It’s just like that, except that the money is going to yourself, rather than to charity! So if you put away $6k into a Traditional IRA every year, the tax savings are really gonna add up.

So you get to put in tax-free money upfront, BOOM. OK, that’s one benefit, but it doesn’t end there. The investments in your Traditional IRA also get to grow tax-free. This is huge because outside of a retirement account, you typically have to pay capital gains taxes when your stock investments increase in value. Given that 94% of your retirement nest egg will come from stock market growth – investing inside a Traditional IRA is gonna save you SO much money in taxes.

If you want to find out about some other ways to reduce your taxes, then keep reading!

Alright and then what happens with the Traditional IRA when you retire? When you turn 59.5, you can start withdrawing money from it, but now those withdrawals will be taxable. So a Traditional IRA lets you make tax-free contributions on the front end, but you don’t get to take tax-free withdrawals on the back end.

The tax benefits of 401ks, which I’m going to explain in just a minute, are a lot like Traditional IRAs. The main difference is that 401ks are sponsored by your employer, while IRAs are not. There are also a few other important distinctions, so I’ll explain that a little bit later in this article.

How about the Roth IRA?

Let’s talk about Roth IRAs. The only difference between a Roth IRA and a Traditional IRA is in the timing.

Remember how with Traditional IRAs, your contributions result in an immediate tax break that year? Well with a Roth IRA, you don’t get that. So even if you contribute to a Roth this year, your tax bill isn’t going to change. That’s because contributions to a Roth are after-tax. So you get your paycheck, taxes get taken out, and then, you can put away some of what’s left into your Roth. With the Traditional IRA, you get your paycheck, put away what you can into your Traditional, and you pay taxes on what’s left.

But here’s the good part. With a Roth IRA, when you turn 59.5, you can start withdrawing money from it 100% tax-free. Yes, tax-free retirement income for the rest of your life. Hell yes!

To recap:

• Traditional IRAs give you a tax break upfront and no tax break in retirement
• Roth IRAs DON’T give you a tax break upfront but you do get a permanent tax break in retirement

So you can get a tax break now OR in the future… but not both. An easy way to think about it is that Traditional IRAs give you immediate gratification in the form of tax benefits today, while contributions to a Roth is delayed gratification because you have to wait until retirement to enjoy the tax benefits.

Reasons to open one or the other

So now that you know the difference, how do you decide which? Let’s go over some of the pros & cons:

First of all, if you’re single and you make over $122k, a Roth is not even an option for you. This also applies if you’re married and you make over $193k. Unlike Traditional, Roth IRAs have income qualification limits. That’s because they’re so awesome. So obviously if you’re over the income limit, this is an easy decision because you’ll just have to go with the Traditional IRA!

Both types of IRAs let your investments grow tax-free, and they both allow you to contribute up to $6k every year. You can even have both, as long as you keep your total contributions to no more than $6k.

Personally, I prefer Roth IRAs by a long shot. I don’t know anyone who enjoys paying taxes (if you do, then you’re weird) – and I love that with a Roth I can just pay taxes once and never pay taxes on it again.

The judgment call you have to make is whether you think your tax rate will be lower or higher in the future. If it’s going to be higher, then it’s better to pay the taxes now with a Roth. If your tax rate is going to be lower when you retire, then it’s better to pay the taxes later with a Traditional. And if your tax rate stays the same, then it doesn’t make a difference whether you go with the Traditional or the Roth.

But think about it – it’s much more likely that tax rates will be higher in the future, not lower. Regardless of your tax bracket. The U.S. government is currently $22 TRILLION in debt, and that number is growing every day. And politicians keep introducing tax cuts in order to get elected, so they’re just kicking the can down the road and one day we’re all going to have to pay for it.

So if you’re on the fence, I say go with the Roth IRA, because even if taxes go up to 50, 60, 70% – no matter what, you’ll have the security of a tax-free retirement.

What is the 401k?

Now let’s talk about 401ks. The name comes from its place in section 401(k) of the Internal Revenue Code – so even though it sounds like something fancy, it’s really not.

A 401k is just a retirement plan that behaves just like the Traditional IRA, EXCEPT that it’s sponsored by your employer. IRAs, on the other hand, have nothing to do with your employer. Anyone can open an IRA, whether you have a job or not.

401ks let you put away a portion of your paycheck pre-tax to save for retirement, the same as a Traditional IRA. The age you can start taking withdrawals is also 59.5.

The best part about 401ks is the employer match. Most companies offer to match your 401k contributions dollar-for-dollar. It might also just be 50 cents for every dollar you put in, or better. At my first job, the employer match was 3-for-1, so they gave $3 for every $1 that I contributed. I know – it was pretty amazing, and it’s literally the main reason why I have a good-sized investment portfolio for someone my age. Employer 401k match is FREE money, so if your job offers it, you should ALWAYS max that out. Period. Life lesson: Never say no to free money.

401k contribution limits are much higher than IRAs. As of 2019, you can contribute up to $19k per year, and if combined with an employer match, you can contribute up to a total of $56k per year. This means you can put a shitload of pre-tax money away for retirement. So yes, 401ks are great.

Now, what about if you’re self-employed? Don’t worry, I’ve got you covered.  If you don’t have a 401k, there are other types of retirement accounts for you, and some of them are even better than what we’ve talked about here. So check out my other blog articles, if you want to learn more about that.

Summary

In general, the ideal combination is to have a 401k plus a Roth IRA. Yes, you can – and SHOULD – have both. You can have a 401k and a Traditional, you can have a 401k and a Roth, and you can even have all 3 – as long as you stay within the contribution limits.

It’s great to understand what all these accounts are and how they work, but just because you have an IRA or a 401k doesn’t mean you have investments.

I want to mention this because I have a friend who once thought that just because she had a Roth IRA, she was investing. But as it turns out, if you don’t actually buy stocks and do stuff, whatever you’ve put into your IRA is just going to sit there in cash, doing nothing and not growing.

So opening a retirement account and putting money into it is one thing, but making investments is a totally different story. Think of 401ks and IRAs as shopping baskets, and the investments as the groceries. You can put stocks in a Roth IRA shopping basket, you can put stocks in a Traditional IRA shopping basket, and or you can put stocks in a 401k shopping basket. But you’re the one who has to pick the stocks, it doesn’t automatically happen for you. Actually I think with 401ks, they generally put you in some index funds by default, but with IRAs, you’re definitely the one who has to take the initiative.

401k plans are generally pretty limited in their investment options, whereas IRAs give you a lot more flexibility. You can’t pick your own stocks in a 401k, and you’ll probably only have a handful of index funds to choose from. But with an IRA, you can invest in whatever stocks and bonds you want, you can buy and sell options, and you can even invest in real estate. Really anything is game.