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IRA vs 401(k): Which is Better for You?

Key facts

  • Contributions to traditional 401(k) plans are made with pre-tax funds, whereas contributions to Roth 401(k) are made with after-tax funds.
  • To choose between a Roth 401(k) and a traditional 401(k), consider whether you’d benefit more from being taxed upfront on contributions or being taxed on withdrawals.
  • The Roth may be better for young investors who expect to be in a higher tax bracket when they retire.
  • For taxpayers in higher brackets, the immediate tax break offered by a traditional 401(k) may be more attractive, particularly if they are likely to be in a lower tax bracket when they retire.

IRA vs 401(k): Which is Better for You?

If you’re an employee, you probably have a workplace retirement savings plan such as a 401(k). Contributing to this type of plan allows you to withhold funds from your paycheck and invest the money in an account where funds compound over time. As a bonus, many employers will match your contributions to these accounts – meaning free money.

Since 2006, employers have been able to offer two types of 401(k): a traditional 401(k) and a Roth 401(k). The right plan for you depends on your tax situation.

401(k) vs. Roth 401(k): The Basics

The traditional 401(k) is a pre-tax plan. You pay no taxes on the money you invest now, but you’ll pay taxes when you withdraw money during retirement. With a designated Roth 401(k), the tax incentives are reversed. You pay taxes on your contributions upfront, but withdrawals from your account are not taxed as long as the following two conditions are fulfilled:

  • It has been at least five years since you made your first Roth 401(k) contribution.
  • You have reach age 59.5 years, become disabled, or passed away and beneficiaries are making withdrawals.

How Do I Choose between Tradition and Roth 401(k)?

If your employer does offer both types of plans, the decision will center around taxes. Do you think you will be better off paying taxes on the contributions now or on withdrawals in the future?

If retirement is some years away, and you think that your tax rate at retirement will be higher than it is now, then you are more likely to benefit from a Roth 401(k) than from a 401(k). That’s because you have a relatively lower taxes rate now, and taking the distributions tax-free at retirement when your tax rate is higher will be advantageous.

If you fall within a higher tax bracket now, a regular 401(k) might be more attractive, especially if you expect your tax rate to be lower at retirement. In this case, you likely will be better off by deferring the taxes now, letting your retirement savings grow and paying taxes during retirement when your tax rate is lower than during the high-salary years.

It’s possible to contribute to both a Roth 401(k) and a regular 401(k) but the total amount across accounts must not exceed the $18,500 maximum annual limit. This strategy is known as tax diversification. Depending on your situation, it may be a good idea to have both types of 401(k)s as it allows you to get both front-end and back-end tax benefits.


Disclosure

Nothing in this article should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. This article is not intended as investment advice, and Wealthfront does not represent in any manner that the circumstances described herein will result in any particular outcome. Financial advisory services are only provided to investors who become Wealthfront clients.

This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Investors and their personal tax advisors are responsible for how the transactions in an account are reported to the IRS or any other taxing authority.

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