401k or IRA - which one should you use?
You have access to a 401k through work. Your employer even matches some of your contributions. Though, a few friends have mentioned a (back door) Roth IRA and its benefits, which sounds enticing. You ask yourself, what are the advantages of each and how do I know which is right for me? Continue reading to learn more about each type of account and the main items to consider when deciding which to use. Surprise, you can (and in most cases should) do both!
Big Benefit - All Retirement Accounts are Tax Deferred
Retirement accounts are not all created equally. Though, they do offer the same benefit across the board - tax deferral. In plain English, this means you do not have to pay taxes while you are earning money in the account. As a result, all of your money stays invested and you earn interest on all of it, as opposed to only a portion. This is also known as compounding interest.
Decision Point #1 - 401k or IRA
401k - generally offered through your employer
Higher contribution limit (23k for 2024)
Savings come out of your paycheck
Limited investment options
Cannot withdraw money until age 59.5 without paying a 10% penalty
IRA - standalone account you open on your own
Lower contribution limit (7k for 2024)
Savings come out of your bank account
Flexible investment options
In a Roth IRA specifically, you can withdraw your contributions anytime
Decision Point #2 - Pre Tax or After Tax (Roth)
You may have noticed you have the ability to contribute to your 401k on either a Pre Tax or After Tax basis. This is true for an IRA also where Pre Tax is called a Traditional IRA and After Tax is a Roth IRA.
Pre Tax - you do not pay taxes up front. Instead you pay taxes when you take money out later.
After Tax (Roth) - the exact opposite of above. You pay taxes upfront and therefore do not need to again when you take money out later.
When deciding which route to go, you should consider both your current and future tax rate. The latter is the tough part since we cannot control the future. Though, there is a general rule of thumb I like to use to start the conversation:
If you are currently in the 22% federal tax bracket or lower then you should use After Tax (Roth) primarily. Contrastingly, if you are a high income earner (24% or higher tax bracket) then you should, at the least, begin to introduce Pre Tax contributions to reduce your current tax liability.
Basic Sample Strategy
First and foremost, max out the employer match on your 401k plan. At the end of the day, this is free money you otherwise would not receive.
Next, open and contribute to a (back door) Roth IRA outside of work. You can either do this on your own if you are comfortable or partner with a Planner.
If your income is above a certain limit, you cannot contribute directly to a Roth IRA. Instead, you would need to utilize the back door method.
Finally, if there are funds left over and your retirement goal calls for it, you can come back to the 401k plan and max it out.
(Note - this is merely a high level example and does not apply to everyone. Consult with an expert to identify your goals and best individual course of action.)
Bringing it all together - Creating and Implementing YOUR plan
In summary, you can use both the 401k and IRA to your advantage. If you don’t have the ability to save too much now, start with the amount of your employer match in the 401k before adding the IRA later.
Zooming out, the biggest consideration is what is most important to you - what are your core values and beliefs? This then creates the foundation of your goals, including retirement (financial independence) - when does it happen and what does it look like? For example, if you want to retire early in your 50s then we may add a third account type to the mix, a Taxable Brokerage account. This is something you can access earlier than an IRA or 401k.
In the end, a Financial Planner can bring it all together - your values, beliefs, goals, current financial picture and desired end state. This is all dynamic and will change over time - as well as legislation and tax brackets. An expert will create a tailored Plan and adjust it as you too continue to develop and change.