As of September 30, 2022, there were approximately $6.3 trillion in assets in 401(k) plans in the country. These assets represented the cumulative value of nearly 625,000 plans with 60 million active participants, among many former employees and retirees. The Individual Retirement Account (IRA) is an equally popular investment vehicle. An estimated 37% of households owned an IRA in 2021, with 28% who owned a Traditional IRA. IRAs had nearly $13.2 trillion in assets at the end of 2021’s third quarter, representing 35% of the total retirement market.
As widely used as these two accounts are, one of the biggest issues most investors face is in deciding between a Traditional and Roth account. Traditional and Roth 401Ks and IRAs can offer distinct tax benefits.
A financial advisor can help you understand these and choose a suitable account for your needs. This article also focuses on some key factors to consider when selecting the right 401k or IRA.
A. Roth IRA vs. a Traditional IRA
Roth IRAÂ and Traditional IRA are both individual retirement accounts that offer tax advantages. However, there are some critical differences between the two.
Key differences between a Roth IRA and a Traditional IRA
1. They are taxed differently, and the timing of the tax benefits differs
The key difference between a Traditional IRA and a Roth IRA is the timing of the tax benefits. With a Traditional IRA, you get a tax break upfront but pay taxes on withdrawals during retirement. With a Roth IRA, you do not get a tax break upfront, but you do not pay any taxes on withdrawals during retirement.
Here’s how this works:
A Traditional IRA allows you to contribute your pre-tax dollars, which means that the money you contribute is not taxed until you withdraw it during retirement. The contributions you make towards a Traditional IRA are tax-deductible as per the prescribed limit. On the other hand, a Roth IRA allows you to contribute post-tax dollars, which means that you pay taxes on the funds you contribute upfront. However, when you withdraw the money during retirement, you do not have to pay any taxes on it, including any earnings you have accrued.
2. They have different rules and penalties for early withdrawals
Since you pay income tax on a Roth IRA at the time of contribution, you have no further tax liabilities. This enables you to withdraw your funds without any penalty or tax consequences anytime you want. A Traditional IRA is not as flexible as you still owe tax on your funds. The contributions are made tax-free, and you pay tax on your withdrawals. As a result, the Internal Revenue Service (IRS) monitors your withdrawals with certain rules according to which you are taxed and imposed with a 10% penalty on withdrawals made before the age of 59.5 and when the account has not been active for at least five years. Withdrawals post the age of 59.5 and from an account that has been active for at least five years are taxed but there is no penalty.
It is also important to know that the IRS offers some exemptions for premature distributions, such as:
- You can draw up to a limit of $10,000 to cover the costs of buying a home if you are a first-time homebuyer.
- You have been diagnosed with a total and permanent disability.
- You use the money to cover qualified higher education expenses.
- You need to pay health insurance premiums while unemployed, and others.
While you can still make early distributions from your Traditional IRA, you may incur a penalty and may have to pay tax. Hence, it is strongly advised first to understand the repercussions of your decisions and assess other options.
3. They have distinct distribution rules
A major difference between Roth and Traditional IRAs is that the latter has Required Minimum Distributions (RMDs). RMDs are mandatory withdrawals that owners must make from their accounts after a certain age. As of 2023, the age limit for RMDs has been fixed at 73. The value of each distribution is decided on the basis of your life expectancy and the total account balance. You must take your first RMD by April 1 of the year, after which you turn 73. Thereafter, all your subsequent RMDs should be withdrawn by December 31 of the concerned year. If you fail to withdraw your RMDs on time, you need to pay a 25% penalty of the required RMD value.
RMDs are put in place so the government can tax you on your distributions. Since a Roth IRA is not taxed in retirement, it does not have any RMDs. You can draw your money whenever you like. You also have complete autonomy over the value of your distributions. Moreover, you can choose not to withdraw your money too.
4. Their income thresholds are not the same
Roth IRA income limits in 2023
| Tax filing status | 2023 Income | Contribution |
| Single, head of household, or married taxpayers filing separately and not living with their spouse at any time during the last year | Less than $138,000 | Up to the annual limit |
| Â | $138,000 to $153,000 | Begin to phase out |
| Â | More than $153,000 | Zero |
| Married taxpayers filing separately and have lived with their spouse at some time during the last year | Less than $218,000 | Up to the annual limit |
| Â | $218,000 to $228,000 | Begin to phase out |
| Â | More than $228,000 | Zero |
| Married taxpayers filing jointly and qualifying widow(er) | Less than $10,000 | Begin to phase out |
| More than $10,000 | Zero |
Traditional IRA tax deduction limits in 2023
Traditional IRAs do not have any income limits, but they do have tax deduction limits.
| Tax filing status | 2023 Income | Deduction |
| Single, head of household, or married taxpayers filing separately and not living with their spouse at any time during the last year | Less than $73,000 | Full deduction up to the contribution limit |
| Â | $73,000 to $83,000 | Partial deduction |
| Â | More than $83,000 | No deduction |
| Married taxpayers filing separately and have lived with their spouse at some time during the last year | Less than $116,000 | Full deduction up to the contribution limit |
| Â | $116,000 to $136,000 | Partial deduction |
| Â | More than $136,000 | No deduction |
| Married taxpayers filing jointly and qualifying widow(er) | Less than $10,000 | Partial deduction |
| More than $10,000 | No deduction |
Key similarities between a Roth IRA and a Traditional IRA
1. They have the same contribution limits
Traditional and Roth IRAs have the same contribution limits. As of 2023, you can contribute up to $6,500Â if you are under the age of 50. If you are 50 or older, you get a catch-up contribution of $1,000 and can contribute up to $7,500 in total.
B. Roth 401k vs. a Traditional 401k
401k accounts also primarily differ on the basis of how they are taxed. Here are some things to know in detail:
Key differences between a Roth 401k and a Traditional 401k
1. They are subjected to different tax rules
A Traditional 401k allows you to make contributions from your pre-tax dollars but taxes you in retirement. On the other hand, a Roth 401k allows you to make contributions with your after-tax income, so you owe no tax in retirement.
A 401k may offer an employer match. The employer match is subjected to federal corporate income tax rules, and contributors/retirees are not impacted by them.
Key similarities between a Roth 401k and a Traditional 401k
1. They have the same distribution rules
An important point to note is that, unlike IRAs, 401ks have the same distribution rules for Traditional and Roth accounts. Both accounts have RMDs, and you must start them from the age of 73 as of 2023 to avoid a 25% penalty of the RMD value. However, if you wish to avoid the RMDs, you have the option to roll over your Roth 401k account to a Roth IRA.
2. They have the same penalty and early withdrawal rules
Traditional and Roth IRAs do not permit early withdrawals before the age of 59.5 years or until the account has been open and active for at least five years prior to the withdrawal. In the case of nonqualified withdrawals, you are subjected to a 10% penalty along with applicable taxes.
3. They have the same contribution limits
A traditional and Roth 401k both have the same contribution limits. As of 2023, you can contribute up to $22,500 if you are under the age of 50. If you are 50 or older, you get a catch-up contribution of $7,500 and can contribute up to $30,000 in total.
4. They have the same loan process
A 401k offers you the option to take a loan against your balance. The rules of the loan are the same for both types of accounts and are primarily determined by the plan administrator or employer.
Common questions about Traditional and Roth accounts
1. Can you have a Roth IRA and a Traditional IRA?
Yes, you can have both a Roth IRA and a Traditional IRA, and many people do. In fact, having both types of IRAs can be a smart strategy for managing your retirement savings and tax liability. Investing in the two accounts enables you to create tax diversification in your retirement savings. This means that you will have some retirement income that is tax-free (from the Roth IRA) and some retirement income that is taxable (from the Traditional IRA). Traditional IRAs require you to start taking withdrawals (RMDs) at age 73, while Roth IRAs have no RMDs during your lifetime. By having both types of IRAs, you can manage your RMDs and potentially reduce your tax liability in retirement.
No matter how many IRAs you own, your total contribution should never exceed the IRS annual limit for any year. If you contribute in excess, you will incur a penalty on the additional amount.
2. Should I contribute to a Roth IRA or a Traditional IRA?
The decision to choose between the two is a personal one and can be taken after careful assessment and evaluation of the two accounts. Each of them can offer unique advantages. You can consult a financial advisor to understand them and arrive at a decision. A financial advisor can help you develop a retirement savings strategy with the right account that takes into consideration your individual circumstances.
3. Can you have a 401k and an IRA together?
Yes, you can have a 401k (Traditional or Roth) and an IRA (Traditional or Roth) at the same time. A 401k is an employer-sponsored account that is offered to you by the company you work for. If you feel you do not have enough investment options or flexibility in it, you can consider opening an IRA on the side. An IRA can be opened with a broker, insurance company, union, etc., and may have greater flexibility in choosing the type of plan and investments.
An IRA has relatively low contribution limits that can limit your retirement savings. A 401k may allow you to make thrice the investments as an IRA. An IRA, in this regard, can serve as an additional cushion to your overall retirement plan. However, managing two accounts may be time-consuming.
To conclude
Deciding between a Traditional or Roth retirement account depends on your individual financial situation and tax bracket. A Traditional account allows you to contribute pre-tax dollars and reduce your taxable income, while a Roth account allows for tax-free withdrawals in retirement. Both types of accounts may have contribution limits, penalties, distributions, etc., that you need to pay attention to. It is also possible to have both types of accounts as long as you stay within the annual contribution limit and are able to manage them effectively. Seeking the advice of a financial advisor can help you make an informed decision about which type of retirement account is best for your individual needs and goals.
WiserAdvisor’s free advisor match service can be a convenient way to find a financial advisor in your area who aligns with your requirements and investment attitude. Answer a few simple questions based on your financial needs, and the match tool will help connect you with 1-3 financial advisors that are best suited to help you.
For additional information on the best retirement strategy for your financial needs, visit Dash Investments or email me directly at dash@dashinvestments.com.