ROTH IRA vs Traditional 401K, What makes the most sense for me?
Quickly after starting your first job, you are bombarded with foreign concepts that you’ve only heard before from an old family member giving unwanted advice: retirement planning, 401K, IRA, the power of compound interest… you get the point. Like me, if you’ve maneuvered your way around these conversations as a teen, you are now facing the task of researching these concepts on your own. When I started my job after college, I felt lost trying to understand what, where, and how to invest for my future. In this article, I hope to help jump-start your understanding of these topics that are key to long-term wealth creation.
Roth IRA vs Traditional 401K, what is the difference?
Without getting into the minutiae, here are three key differences that can help you decide whether a Roth IRA or Traditional 401K makes more sense: taxes, income, and limits.
Taxes
While both options have tax advantages, the application of these tax advantages occurs at different times. For example, the Roth IRA allows you to put post-tax money into an investment account but withdraw these funds – and their growth – tax-free in retirement. In other words, you pay taxes now and reap the rewards later. The Traditional 401K, on the other hand, does the exact opposite. You lower your current taxable income by depositing pre-tax dollars into an investment account and instead pay taxes upon withdrawal. What are the implications of this? Well, advisors often tell young individuals to invest into a Roth IRA as most college graduates find themselves in a relatively lower tax bracket. To help with your decision, compare your current tax bracket to your projected tax bracket during withdrawal. Does it make more sense to reap the rewards now or during retirement?
To check your current tax bracket for the 2022 - 2023 year, Nerd Wallet provides a table outlining the threshold for each income tax bracket here.
Income
In addition to thinking about taxes, your income may guide your decision to invest in a Roth IRA or Traditional 401K. These two options have different rules when determining qualification. While the Traditional 401K invites individuals regardless of tax bracket, the Roth IRA is only for those who make a modified adjusted gross income less than $144,000 for 2022 and $153,000 for 2023 (if filing single). If your income does exceed this limit, there are other alternatives you may consider.
Limits
Lastly, the contribution limits for these accounts are important to understand. The Traditional 401K allows contributions up to $20,500 for 2022 and $22,500 for 2023 (and if your workers age exceeds 49 years, you can contribute additional “catch-up” dollars). The Roth IRA, on the other hand, allows contributions up to $6,000 per year for 2022 and $6,500 for 2023 (“catch-up” dollars also apply under the same circumstances).
So which is right for me?
All things considered, everyone faces unique circumstances that may warrant one plan over another. However, there are two universal rules to consider when making your decision. Firstly, if your company offers a 401K match, many recommend at least contributing enough to receive your company match. If you choose to forego this, you may be leaving money on the table. Secondly, note that you need not choose one option over the other. You can invest in both the Roth IRA and the Traditional 401K, should your budget allow this.
Of course, I am not a financial advisor, and I encourage you to research information beyond this paper when making any investment choices. The above text is published for informative purposes only and should not be seen as investment advice or a recommendation.
