5 Differences Between Traditional IRA vs. Roth IRA vs. 401k

Are you saving enough for retirement? Experts agree that Social Security payments do not provide enough income for a comfortable retirement for most people. A good rule of thumb: you’ll need about 80% of your final, pre-retirement income to have what you need to pay your expenses in retirement.

To help you plan for retirement, let’s compare traditional IRAs, Roth IRAs, and 401(k) plans and examine the five differences between them.

Traditional IRAs, Roth IRAs, and 401(k) Plans Explained

Before you choose a retirement plan, we can help you understand which plans are available.

Traditional IRA

A traditional IRA is a retirement plan that allows investors to make pre-tax contributions to the plan. Here are some of the key characteristics of a traditional IRA:

• Traditional IRA contributions are made on a pre-tax basis, often via a payroll deduction for employer-sponsored plans.
• People who open an individual IRA may deduct their contributions when they file their federal tax return. (The deduction does not apply to employer-sponsored plans.)
• Below a specified income level, you may also be eligible for the Saver’s Tax Credit to help reduce your tax burden.
• Any investments you make grow on a tax-deferred basis.
• You may contribute up to $6,000 in 2022. People over the age of 50 may contribute an additional $1,000 as a catch-up contribution.
• Mandatory distributions begin at age 72. (Age 70 ½ if you reach that age prior to January 1, 2020.) You may begin taking distributions at 59 ½ but keep in mind that your distributions will be taxed.

As a rule, traditional IRAs are best suited to people who believe they will be in a lower tax bracket in retirement than they are during their working years.

Roth IRA

Roth IRAs have a lot in common with traditional IRAs, but there are some key differences. Here are the features of a Roth IRA:

• The key difference between Roth and traditional IRA plans is that Roth IRA contributions are made on a post-tax basis.
• Contributions are not tax deductible.
• The contribution limit is the same as it is for traditional IRAs: $6,000 per year plus an additional $1,000 in catch-up contributions for people over the age of 50.
• Any investments you make grow tax-free.
• You will not pay taxes on your qualified distributions.
• You can make penalty and tax-free withdrawals once you reach the age of 59 ½. There is no minimum distribution requirement for the original owner of an IRA, although there is one for beneficiaries.

A Roth IRA may be the best choice for anyone who anticipates being in a higher tax bracket after they retire than they are during their working years.

401(k) Plan

401(k) plans are a popular choice for retirement, which is why many employers offer them to employees. The investment potential is high when compared to IRA plans. Here are the most important features of a traditional 401(k):

• For your 401(k) plan, the maximum contribution for 2022 is $20,500 with an additional catch-up contribution of $6,500 for people over the age of 50. The high contribution limits can enable people to accumulate savings quickly.
• 401(k) contributions are made on a tax-deferred basis.
• Many employers offer matching funds.
• You may begin making penalty-free withdrawals once you reach the age of 59 ½.
• After you retire, you may not make additional contributions. Instead, you will need to roll your 401(k) into an IRA if you want to keep contributing.
• Mandatory distributions begin at the same age as they do for traditional IRAs, 72.

401(k) plans are ideal for anybody who is traditionally employed, particularly when employer matching funds are available.

5 Differences Between Retirement Plans

Now, let’s review some of the key differences between traditional IRAs, Roth IRAs, and 401(k) plans.

#1: Tax Differences

Arguably the most important difference between the three retirement plans we have identified is their impact on your taxes. Traditional IRAs and 401(k) plans allow you to contribute money on a pre-tax basis. This has the effect of reducing the amount of tax you pay now, since your taxable income will be reduced by the amount of your contribution. However, you will need to factor in tax payments when you begin to take distributions.

By contrast, contributions to a Roth IRA are made on a post-tax basis. The advantage is that, while you pay more taxes now, you’ll be able to take tax-free distributions after you retire.

#2: Contribution Limits

The amount you can invest within a retirement plan is dictated by the type of plan you choose. With a traditional or Roth IRA, the maximum contribution for 2022 is $6,000. As we noted above, there is an additional catch-up contribution of $1,000 available to anybody over the age of 50. This amount may change for 2023 but no changes have been announced as of this writing.

The contribution limits for 401(k) accounts are more than three times the limit for IRAs. For 2022, the maximum contribution limit for people under 50 is $20,500, and there is an additional catch-up contribution of $6,500 for people 50 and over, bringing their total contribution limit to $27,000.

#3: Eligibility Requirements

While there are no income requirements for traditional IRAs and 401(k)s, there is a maximum income limit for contributions to Roth IRAs. Here are the limits for 2022:

• $144,000 for people filing an individual tax return
• $214,000 for people who are married and filing jointly

People who earn less than $129,000 per year ($208,000 if married and filing jointly) may make the full contribution of $6,000. Those with income between $129,001 and $144,000 (between $208,001 and $214,000 if married and filing jointly) may make a reduced contribution. Anybody who earns more than the above thresholds cannot contribute to a Roth IRA.

#4: Required Minimum Distributions

Both traditional IRAs and 401(k)s have a minimum distribution requirement. While you may, as noted above, begin to make penalty-free withdrawals from any of the plans we have discussed at age 59 ½, you must begin to take distributions from 401(k) and traditional IRAs when you are 72. The required distribution amount is based on your age and the amount of money in your account. You can read more about how to calculate the required minimum distribution here.

Roth IRAs do not have a required minimum distribution for the original plan owner. On a practical level, this makes Roth IRAs useful because you can allow your money to grow until you need it. However, if you name a beneficiary for your Roth IRA, they will be required to take distributions to avoid penalties.

#5: Employer Matching

Many employers who provide a 401(k) to their employees also offer matching funds. They will contribute the same amount to your plan as you do up to a specified limit. If you maxed out your employee contributions and your employer matched them, you could have up to $41,000 in contributions per year instead of $20,500.

Because IRAs and solo 401(k) plans are individual plans, employer matching is not an option. It’s for this reason that people who have a 401(k) with employer matching should take advantage of it and open an IRA as a secondary account.

Which Type of Retirement Plan Should You Choose?

There are many factors to consider before you choose between a traditional IRA, a Roth IRA, or a 401(k). Here are some things to keep in mind:

1. Your income level before and after retirement. If you expect to be in a lower tax bracket after you retire, which many people are, then you may want to opt for one of the tax deferred options: a traditional IRA or a 401(k). If you expect to be in a higher tax bracket, then a Roth IRA may be your best bet.
2. Your current tax obligations. If you’re someone who is in a high tax bracket or seeking options to reduce your tax bill, then you may want to choose a traditional IRA or 401(k) because the pre-tax contributions will reduce your taxable income now.
3. When you want to withdraw money. For example, if you have an employer-sponsored IRA, you know you’ll need to take the minimum required withdrawals starting at 72. It may be beneficial to open a Roth IRA as a second (or third) account because the money can continue to grow tax free, and you won’t be required to withdraw anything until you need it.
4. How much you want to contribute. The contribution limits for both traditional IRAs and Roth IRAs are considerably lower than the limit for 401(k) plans. It’s for that reason that many people choose an IRA as a second account if they have a 401(k). Anybody who maxes out on their 401(k) contribution but wants to set more money aside for retirement can do so with a traditional or Roth IRA.
5. Employer contributions and matching. If your employer offers a 401(k) plan with matching funds, you would be turning down free money if you didn’t participate.

We recommend reviewing these factors before you make your choice. It's also important to remember that your investments are not insured through the NCUA.

Choosing the right retirement account is something that has the potential to make your retirement enjoyable and stress-free. The information we’ve included here can help you evaluate your options and select the best retirement savings account (or accounts) for your needs. 

Are you ready to open a retirement account? A Leaders Investment Services financial advisor can help you navigate these important steps in planning for retirement. Also, learn more about investment through our free Deep Dive Into Investments Guide.