401(k), IRA, and Roth IRA: Understanding the Differences

When planning for your financial future, it's crucial to understand the different types of accounts available to you. Each account serves a different purpose, offers unique tax benefits, and plays a role in your overall investment strategy. In this post, we'll explore the differences between an IRA, Roth IRA, retirement accounts (like a 401(k)), and brokerage accounts, and when you might want to use each one.

1. IRA (Traditional IRA)

What It Is: An Individual Retirement Account (IRA) is a tax-advantaged account designed to help you save for retirement. Contributions to a traditional IRA are typically tax-deductible, meaning they reduce your taxable income in the year you contribute. The investments in your IRA grow tax-deferred, which means you don't pay taxes on the earnings until you withdraw the money during retirement.

When to Use It: A traditional IRA is a good choice if you expect to be in a lower tax bracket during retirement than you are currently. By deferring taxes until later, you may end up paying less in taxes overall. It's also a suitable option if you don't have access to a workplace retirement plan, like a 401(k), or if you want to supplement your retirement savings.

Key Considerations: You must begin taking required minimum distributions (RMDs) from a traditional IRA starting at age 73. Withdrawals before age 59½ may be subject to a 10% penalty in addition to income taxes.

2. Roth IRA

What It Is: A Roth IRA is another type of individual retirement account, but with a key difference: contributions are made with after-tax dollars. This means you don't get an immediate tax deduction, but your investments grow tax-free, and qualified withdrawals during retirement are also tax-free.

When to Use It: A Roth IRA is a great option if you expect to be in a higher tax bracket in retirement or if you prefer the flexibility of tax-free withdrawals. It’s also beneficial for younger investors who have a long time horizon for their investments to grow. Unlike a traditional IRA, there are no required minimum distributions (RMDs), so your money can continue to grow tax-free as long as you want.

Key Considerations: There are income limits for contributing to a Roth IRA, so high earners may not be eligible to contribute directly. However, a "backdoor" Roth IRA conversion is a strategy some use to get around these limits.

3. Retirement Accounts (401(k) and Similar Plans)

What It Is: A 401(k) is a type of employer-sponsored retirement plan. Contributions are made with pre-tax dollars, reducing your taxable income in the year you contribute. Like a traditional IRA, the investments grow tax-deferred, and taxes are paid upon withdrawal during retirement. Many employers also offer a Roth 401(k) option, which allows for after-tax contributions and tax-free withdrawals, similar to a Roth IRA.

When to Use It: If your employer offers a 401(k) with a matching contribution, it’s generally a good idea to contribute enough to get the full match, as it’s essentially free money. A 401(k) is also beneficial because it allows for higher contribution limits compared to IRAs.

Key Considerations: Like a traditional IRA, 401(k) plans require RMDs starting at age 73, and early withdrawals may incur penalties. However, 401(k) loans and hardship withdrawals may offer some flexibility if you need access to your funds before retirement.

4. Brokerage Account

What It Is: A brokerage account is a taxable investment account that allows you to buy and sell a wide variety of investments, including stocks, bonds, mutual funds, and ETFs. Unlike retirement accounts, brokerage accounts offer no tax advantages—capital gains and dividends are taxed in the year they are realized.

When to Use It: A brokerage account is ideal for general investing purposes, short-term goals, or as a supplement to your retirement savings. If you’ve maxed out your retirement account contributions and still want to invest more, a brokerage account provides flexibility without the restrictions on withdrawals that come with retirement accounts.

Key Considerations: Since there are no contribution limits or penalties for withdrawals, a brokerage account offers more flexibility but requires careful tax planning to manage the impact of capital gains and dividends on your taxable income.

When to Use Each Account

• 401(k) or Other Retirement Plans: Start here, especially if your employer offers a match—contribute enough to get the full match before considering other accounts.

• Traditional IRA: Use it if you expect to be in a lower tax bracket in retirement, or if you want a tax deduction now.

• Roth IRA: Choose this if you expect to be in a higher tax bracket in retirement or want the flexibility of tax-free withdrawals.

• Brokerage Account: Use this for additional investments after maximizing retirement contributions, or for goals that are not retirement-related.

*****

Want to learn more about investing and planning for retirement? Book a free 1:1 consultation with a coach, or download our free Early Retirement Guide.