I’m Confused — What the Heck is a 401(k), IRA, and Roth?

Roth—401(k)—IRA—oh my! What do all these numbers and letters mean anyway? Perhaps you know that they have something to do with retirement, but that’s all you know. It’s important to know the different options for saving for retirement so that you can get the best bang for your buck.

You want to understand the pros and cons of each so that you can make the best decision for your future. So if your head is spinning because you’re confused about the differences between a 401(k), Roth, and IRA, read on, my friend!

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IRAs

IRA stands for Individual Retirement Account. It’s a special savings account that helps people save for when they retire, and it usually offers tax advantages.

There are two different kinds of IRAs: traditional IRAs and Roth IRAs. While both accounts allow money to grow tax-free, the main difference between the two is when you pay taxes. You pay income taxes before you contribute to the Roth IRA, which means you’re not taxed when you withdraw money for retirement. But with the traditional IRA, you pay income taxes after withdrawing money to retire. (Keep in mind that you may be at a higher tax bracket toward the end of your life and may end up paying more in income taxes in the long run.)

Another difference is with contribution limits. Just about everyone with earned income can donate to a traditional IRA (higher income earners may be limited in deductibility), but the Roth IRA has income limits for donating. The income limits for contributing to your Roth IRA vary by year, so to see where you fall in the income limits, click here. Because of these limits, if you’re a high-income earner, a Roth 401(k) may be the only way you can utilize a Roth account (more on this later—keep reading).

Additionally, the traditional IRA requires that you begin withdrawing funds by the time you reach 72 years of age whereas Roth IRAs have no such requirement. Distributions may be subject to taxes if certain requirements or exceptions are not met. Please consult with your advisor.

401(k)s

A 401(k) plan is an optional, employer-sponsored, tax-deferred retirement program to help employees save for retirement. Employees can elect to have a portion of their paychecks deducted and directly deposited into their 401(k) accounts. Sometimes companies will even contribute to or match what employees deposit into their 401(k)s. This is an added benefit that many employees enjoy.

Just like there are traditional IRAs and Roth IRAs, there are also traditional 401(k)s and Roth 401(k)s. The big difference is that with a Roth 401(k), there are no income limits like there are with a traditional Roth account. So if you want the up-front tax advantages of a Roth, but you’re a high income earner, your only option for a Roth account is if your employer offers a Roth 401(k) option.

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Similar to traditional IRAs, with traditional 401(k) accounts, you pay taxes when you withdraw money for retirement. If you’re at a higher income tax bracket when you withdraw, you may end up paying more income taxes than you would have with an after-tax contribution option such as a Roth account.

It’s important to note that all 401(k) plans—both Roth and traditional—require people to begin withdrawing funds when they reach age 72 (keep reading to find out more about that).

Younger vs. Older Investors

You may be wondering which retirement account is the best to choose, depending on your age. Having a tax-free stream of income, thanks to a ROTH IRA or ROTH 401(k) can be strategic.

It all basically depends on when you want to pay taxes.

If you’re a young investor currently at a low tax bracket and you expect your income to grow considerably over the years, then you may want to choose a retirement account in which you’re paying taxes before you contribute.

This is attractive to older investors as well who do not want to pay taxes at a higher rate (because they’re in a higher tax bracket) upon withdrawal of retirement funds.

In the end, contributing to any kind of retirement account helps to lower your current taxable income. And instead of “either/or,” why not both? Consider contributing to both a 401(k) plan and IRA plan (see below about diversification).

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Rolling Over

No, we’re not talking about the latest trick you’ve taught your dog—we’re talking about converting retirement accounts from one type to another type. For example, sometimes you can “roll over” a Roth 401(k) into a traditional Roth IRA to avoid the required minimum distribution (RMD) rule, especially if you don’t really need the money when you’re 72 years old. And if the market happens to be down when you reach that age, you don’t want to be forced to withdraw money if you don’t need it. If you can manage it, it’s better to leave it alone so it can continue to grow.

Remember that there are specifics that you should consider before rolling an account over, including fees, distribution options, and other fine print. This is where consulting with a trusted financial planner can help you navigate the details and make sure not to mess everything up! In addition to the options listed here, there may be other options available. You should also consider your other options before rolling over retirement savings. Consider the differences in investment options, services, fees and expenses, withdrawal options, required minimum distributions, other plan features, and tax treatment.

Diversification

When considering investment options, it’s always good to consider diversifying your accounts. Because different accounts have different pros and cons, using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.

For example, if you have a Roth IRA that you are never required to begin withdrawing from and you’ve already paid taxes on the money in that account, you can allow it to grow infinitely as you use your 401(k) or Roth 401(k) to live off of in your retirement. The untouched Roth IRA can be designated as an inheritance that can be passed on to your family. Or, if you develop health problems, the Roth IRA can be dipped into to offset the costs of medical bills.

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Finally, if this all seems like Greek to you, then do yourself a favor and contact a trusted and knowledgeable financial advisor to help walk you through the process. You don’t have to go this alone; just reach out and get the help you need to plan for a financially independent future for yourself and your family.