Which Is the Best Retirement Account for You?

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best retirement account

Traditional 401(k) vs. Roth IRA

I graduated from college with a Finance degree but felt woefully unprepared when it came to personal finance.  Tragic, right?  Most of my classes had a concentration on corporate financial classes.  After I graduated, financial pundits seemed to really encourage contributing to a Roth IRA (Individual Retirement Account).  Even the yearly tax software I used asked if I contributed to a Roth IRA for the year.  By then, the marketing machine for the Roth IRA had persuaded me to contribute.  That first year, I was able to scrape together $3,000 to contribute to a Roth IRA and have maximized that amount ever since.

 

The Roth IRA was not established until the Taxpayer Relief Act of 1997.  So, the first year individuals could contribute was 1998.  Since it is a fairly new retirement plan, people are still trying to figure which is better- a Traditional or Roth.

Features

Traditional IRA

Roth IRA

Who can contribute?

You can contribute if you (or your spouse if filing jointly) have taxable compensation but not after you are age 70½ or older.

You can contribute at any age if you (or your spouse if filing jointly) have taxable compensation and your modified adjusted gross income is below the phase outs

Are my contributions deductible?

You can deduct your contributions if you qualify.

Your contributions aren’t deductible.

How much can I contribute?

The most you can contribute to all of your traditional and Roth IRAs is the smaller of:

$5,500 (for 2017), or $6,500 if you’re age 50 or older by the end of the year; or your taxable compensation for the year.

What is the deadline to make contributions?

Your tax return filing deadline (not including extensions). For example, you have until April 15, 2018, to make your 2017 contribution, but please see IRS Publication 509, Tax Calendars, for how statewide holidays may delay this deadline.

When can I withdraw money?

You can withdraw money anytime.

Do I have to take required minimum distributions?

You must start taking distributions by April 1 following the year in which you turn age 70½ and by December 31 of later years.

Not required if you are the original owner.

Are my withdrawals and distributions taxable?

Any deductible contributions and earnings you withdraw or that are distributed from your traditional IRA are taxable. Also, if you are under age 59 ½ you may have to pay an additional 10% tax for early withdrawals unless you qualify for an exception.

None if it’s a qualified distribution (or a withdrawal that is a qualified distribution). Otherwise, part of the distribution or withdrawal may be taxable. If you are under age 59 ½, you may also have to pay an additional 10% tax for early withdrawals unless you qualify for an exception.

Source: IRS.gov

 

Which Is Better: Traditional or Roth?

Some claim it is more advantageous to contribute to a Roth account than a Traditional account due to the fact that people tend to contribute fixed amounts into their accounts.  

 

best retirement accountLayman’s terms: if you’re going to contribute $100 to your Traditional IRA, you’re just as likely to contribute $100 to your Roth.  Therefore since the Roth uses after tax dollars, you would be better off.  

 

Now let’s say that you’re extra smart.  You adjust your contribution amount according to the account that you’re contributing to.   

 

Tax Brackets: High

If you are currently in a high-tax bracket and believe that your tax rate will decrease when you are in retirement, it would make sense for you to contribute to a Traditional IRA.  In that case, you would be able to reduce the amount of taxes you pay immediately.  And, in retirement, you would pay less taxes when you withdraw your investment.

 

Converting the IRA

In the future, if you decide that you would like to convert your Traditional IRA into a Roth IRA, you have the ability to do this rollover.  This will allow you to take tax-free withdrawals, but you will be required to pay taxes on the contributions that you made over the years.  Most people, if they choose to do the rollover, do so when their tax rate is at the lowest point in order to minimize the amount of taxes that they pay to IRS.

 

Tax Brackets: Low

If you are in a low-tax bracket and believe that your tax rate will increase when you are in retirement, it would make sense for you to contribute to a Roth IRA.  Then, you would pay taxes lower initially with the anticipation that when you are in retirement, you should save money on the taxes you would have paid on the withdrawn investment.

 

Tax-Free Withdrawals

best retirement accountThis is another major benefit of utilizing the Roth IRA.  Up to $10,000 during your lifetime can be withdrawn tax-free in order to purchase a principal residence as a first-time homebuyer.  The funny thing about this rule is you don’t actually have to be a first-time homebuyer.  The only requirement is that you haven’t previously owned a home within the last 24 months.  So, for those individuals who have previously owned a home, you can still withdraw up to $10,000 during your lifetime to take advantage of this benefit.

 

No Required RMDs

Finally, a Roth IRA does not force Required Minimum Distributions (RMDs) at 70.5 years old, unlike a Traditional IRA.  This is a huge benefit if you become wealthy and no longer need the distributions.  That way if you do not need the funds in your Roth IRA, they can continue to grow untouched.  

 

Eligibility Requirements

As you can see on the below chart, the Traditional IRA has a much lower MAGI than does the Roth IRA.  The IRS is very concerned about receiving their money today and is clearly not worried about the future when it comes to economic matters.

2017 Roth IRA Income Requirements

Filing Status

Modified adjusted gross income (MAGI)

Contribution Limit

Single individuals

< $118,000

$5,500

≥ $118,000 but < $133,000

Partial Contribution

≥ $133,000

Not eligible

Married (filing joint returns)

< $186,000

$5,500

≥ $186,000 but < $196,000

Partial Contribution

≥ $196,000

Not eligible

Married (filing separately)

Not eligible

$5,500

< $10,000

Partial Contribution

≥ $10,000

Not eligible

2017 Traditional IRA Deduction Limits

Filing Status

Modified adjusted gross income (MAGI)

Deduction Limit

Single individuals

≤ $62,000

Full deduction up to the amount of your contribution limit

> $62,000 but < $72,000

Partial Deduction

≥ $72,000

No deduction

Married (filing joint returns)

≤ $99,000

Full deduction up to the amount of your contribution limit

> $99,000 but < $119,000

Partial Deduction

≥ $119,000

No deduction

Married (filing separately)

Not eligible

Full deduction up to the amount of your contribution limit

< $10,000

Partial Deduction

≥ $10,000

No deduction

Non-active participant spouse (i.e., those with spouses who earn no income)

≤ $186,000

Full deduction up to the amount of your contribution limit

> $186,000 but < $196,000

Partial Deduction

≥ $196,000

No deduction

Unfortunately, I do not know what the future holds.  If I did, it would be a no brainer to utilize basic math skills to deduce which made more sense between the Traditional and Roth.  Unsure of the future, I tend to spread out my risk.  Therefore, I contribute money to my Traditional 401(k) and also my Roth IRA to diversify my tax-rate risk.  

 

Another Option- Nondeductible IRA

best retirement accountIf you are ineligible to contribute to either a Traditional IRA or Roth IRA, you can choose a Nondeductible IRA, which has the worst features of all IRAs.  You pay taxes immediately like a Roth IRA.  When you withdraw, you must pay taxes again, like a Traditional IRA.  This seems terrible, but thankfully there is a loophole.  

 

You can open up a Traditional IRA, and for tax purposes, it will be non-deductible when you file taxes.  However, the very next day, you can convert the Traditional IRA into a Roth IRA.  If you leave the contribution in as cash and don’t buy any stock or earn any interest, you will not be required to pay any taxes on the earnings.  This is essentially a backdoor Roth IRA, which is completely legal.  Yes, you can really do this!!  If you couldn’t, why would Vanguard show you exactly how to do so?

 

An Example

Let’s say you have $20,000 in an existing Traditional IRA account.  Then, you start to make too much money, but you still want to contribute.  So, you decide to do a nondeductible contribution of $5,000 and try to convert just the $5,000 over into a Roth IRA.  Well, the IRS is going to tax you on a percentage of the total amount in your Traditional IRA.  

 

For this example, let’s assume you are in the 25% tax bracket.  Then, the formula would be $5,000, which is your non-deductible IRA contribution, divided by the total amount in the IRA, which will include the $5,000 you contributed from the non-deductible IRA, plus the existing $20,000 that is in the Traditional IRA account.  Therefore, your tax-free rate will be 20% based on:

$5,000/($5,000+$20,000) 

So, $1,000 will go tax-free into your conversion Roth IRA.  Then, the remaining $4,000 that you convert into the Roth IRA will be taxed at the 25% tax rate, which means you will have $1,000 that you have to pay in taxes.

 

Now that I have walked you through how to do a nondeductible to Roth IRA conversion, be careful.  There have been rumors that Congress is going to try to close this loophole at some point, so make sure you are following along with the latest laws before you put this into action.

 

How Much?

People ask me how much they should contribute to their 401(k) for retirement all the time.

 

My answer is always the same– AS MUCH AS POSSIBLE.  Right now as I am writing, each individual is allowed to contribute $18,000 into their 401(k) per year.  This is the figure for which you should be striving.  

 

Now let me take a step back, as I’m not so callous to believe everyone has the ability to contribute this maximum amount.  If you’re one of the lucky ones that actually get a 401(k), take advantage.  Currently, less than 50% of Americans are offered a 401(k).  Think about that for a second.  Only 1 out of 2 Americans have the ability to contribute to a 401(k).  This is mind boggling!!!  The average Social Security monthly benefit is $1,335, according to the Social Security Administration.

 

Company Match

If you can’t contribute the maximum amount, I encourage you to contribute at least to your company’s match.  The average 401(k) contribution company match is currently 3%.  While that may seem paltry, if you start at age 22, based on a 8% rate of return from the S&P 500 and using the average US salary of $52,000, you can become a millionaire.  Check out the chart below.  For those that are curious, I also provide a column if you are able to contribute the maximum contribution to your 401(k).  Compounding interest is wonderful!!

Age

3% Growth

Maximum w/ Match

22

$3,120.00

$19,560.00

25

$15,298.42

$93,434.04

30

$43,835.62

$262,010.60

35

$86,855.57

$510,249.58

40

$151,211.00

$875,566.59

45

$246,973.65

$1,412,938.83

50

$388,945.19

$2,203,147.36

55

$598,877.29

$3,364,887.60

60

$908,733.53

$5,072,563.70

65

$1,365,482.40

$7,582,434.35

If you carry debt, I would encourage you to continue to pay that down before you try to maximize your 401(k).  The easy math behind this is, if you are contributing to a 401(k) that on average makes 8% a year, but you pay 19% a year on a credit card balance, you would get a bigger return on your money by paying off the credit card balance.  However, if you don’t have any debt except for your mortgage, I would encourage you to maximize your 401(k) as much as possible.  Following the chart above, it will definitely pay off in the long run.  

 

Roth 401(k)

One of the newest wrinkles in the 401(k) world is the Roth 401(k).  This is just like a Roth IRA with employee contributions that are not tax-deductible but will grow tax-free.  Please note that the employer portion will be applied to the Traditional 401(k) account.  The government still wants to tax you on this amount.  Otherwise, it would be a no-brainer to get a match using after-tax dollars from your employer.  So, now that we’ve gone through the options, which one should you do?  

 

50%/50%

I think the perfect allocation is 50% in the Roth IRA and 50% in the Traditional 401(k).  Unfortunately nobody knows what the tax future holds.  So whether they go up or down, you will have a hedge of protection in the future.

 

If you are potentially eligible to invest in a Roth IRA, one downside to be aware of is your Modified Adjusted Gross Income (MAGI).  If you exceed your MAGI, you will be ineligible to contribute to your Roth IRA.  In a previous article, I wrote in depth on the Roth IRA, so click over there if you’d like more information.   

 

Remember, between the Roth IRA and Traditional 401(k), you are able to contribute a total of $23,500.  $18,000 would go towards your 401(k) and $5,500 towards your Roth IRA.  If you are over 50, you get to save an additional $6,000 in your 401(k) and $1,000 in your Roth IRA.  So, make sure contributing to a Roth 401(k) doesn’t push you over the Roth IRA limit before you contribute.

 

So readers, what is your contribution strategy?  Do you do a mix of Traditional 401k and Roth IRA contributions?  Share your thoughts below.

Mustard Seed Money

Welcome to the website. A mustard seed is a very small seed but astonishingly grows very large over time. My hope is that through your financial journey that your small investment in time, money and faith will grow beyond anything that you could ever imagine.

58 Comments

  1. Good summary. We’re especially wary of Roth IRAs since you’re paying the highest marginal tax rate on those dollars. With that said, they’re great if you have some cash sitting around that you want to invest but want to be able to access well before retirement comes, or, if you’re ineligible for a traditional IRA or 401k.

    Like you, I use a mixed strategy, and am also keenly aware that the government may change the rules at any time. It’s harder to imagine here, but other nations have nationalized investment accounts like these (or at least banned you from investing in anything but government bonds that were rapidly losing value). Here, the government proposed something similar once, but then almost immediately backed off. Like all investments, it’s probably best to hedge your bets (and accounts) by using multiple types of accounts, including taxable ones. (That’s the main piece I would add.) And then sleep easy knowing that we can’t know the future anyway, and worrying does nothing at all.

    Meanwhile, you’re dead on about hitting the 401k limits each year! That’s one of my biggest goals each year.
    Finances with Purpose recently posted…Financial Update (June 2017): Inching Towards Success…My Profile

  2. Great summary! I can’t see myself anywhere near my current tax bracket in retirement, so I have been contributing to our traditional 401k even though we have the Roth option. We max out our backdoor Roths as well, but it’s only a fraction of what we put in our 401k.

    Crossing my fingers that tax law changes don’t screw me over!
    Dr. Curious recently posted…Yes, I’ll Wrestle with YouMy Profile

  3. Very nice run down of the accounts! Personally, I max out my 401K. It is in Vanguard so I can take advantage of both company match hand low cost index funds. Mr. Adventure Rich and I are in a higher tax bracket, so that works out well for us! Mr. AR recently started a new job and we are in the process of rolling his 403b (previous job) to a Vanguard IRA. Thanks for the great post!
    Mrs. Adventure Rich recently posted…Visible Beauty in Our Blog PhotosMy Profile

    • Thanks for stopping by!!! That’s awesome that you are able to max our your 401k. I don’t always hear that these days. Sounds like you are well on your way 🙂

  4. Nice summary and love the comment “as much as possible”. I find it amazing how many people either don’t put into a 401K or put in a minimal amount (good start). When I ask, why they don’t put in more, it because they don’t have the money. Interesting since they eat out all the time, or are constantly on vacations, or some other excuse. Even the smallest lifestyle change can payoff huge in the long run.
    FIbythecommonguy recently posted…Dollars and cents behind the moveMy Profile

    • I totally agree that it’s a matter of how much you want it. There is almost always fat in any budget that people think are non negotiable but are luxuries for others 🙂

  5. This a a really great resource for retirement accounts. Nicely done!
    I have an advantage in that I’m not planning on being in this high a tax bracket in retirement so tax deferred all the way for me. I’m also disciplined enough to invest the tax savings so that really helps me beat out the Roth option.
    As for the non deductible IRA contribution my wife and I invest each year, we take advantage of the backdoor opportunity into the Roth. That helps diversify our accounts from a tax standpoint.

    Tom @ HIP
    High Income Parents recently posted…Please Stop Telling me my Kid’s Money Habits are Formed by Age 7My Profile

  6. We’re definitely in the split camp. Question, I know you work got the government. Do you get a 457? A 457 doesn’t count against the 401k limits. So if you work for a non profit with a 457 you potentially contribute 36k to 401k equivalents.
    FullTimeFinance recently posted…Important Dates and Goal SettingMy Profile

    • Wow that’s great info Full Time Finance. I currently have a TSP. But I’ll have to look to see if there are any loopholes with it. If you’re aware of any I’m happy to sock away some more money 🙂

  7. I have a 457 instead of a 401(k). They function almost exactly the same, except that you can access the money from a 457 penalty free as soon as you leave your employer. I’ve been maxing it out every year to fill up the space between when I want to retire early and when I hit normal retirement age and can access the rest of my funds.

    I also use a backdoor Roth IRA. I like the idea of having access to both buckets and being able to make withdrawal decisions based on whatever situation I happen to find myself in when I get to that point.
    Matt @ Optimize Your Life recently posted…Why I Save So MuchMy Profile

  8. You analysis of the different account is quite comprehensive. With me being a personal finance guy from Canada, I still find that all these retirement accounts confusing and it takes quite a bit of effort to make sure you follow all the rules.

    Fortunately for Canadians like me, we only have one retirement account that we need to worry about – the RRSP. We can contribute a max on 18% of our income from the previous year. If we have income then our contribution room will grow. Otherwise, we can’t contribute to our RRSP. We can deduct the contribution amount from our income to lower our taxes.
    Leo T. Ly @ isaved5k.com recently posted…Would You Borrow Money To Invest?My Profile

    • Thanks for sharing Leo!!! That’s really interesting that you’re capped at 18%. Seems like they should allow you to contribute as much as you want 🙂

    • Sounds like a great plan. I definitely like to contribute to the match and then diversify to my Roth IRA. Sounds like you are doing a similar strategy 🙂

  9. When I first heard of a backdoor Roth I couldn’t believe that it was legal. I thought it would certainly involve needing a lawyer and a tax professional. Nope it takes like 3 clicks online. So easy. If they ever do close that loophole they need to remove the deduction limit on the traditional IRA or else there is no reason to contribute to it if you make a slightly above average income.
    Grant @ Life Prep Couple recently posted…Stop Mindlessly Going To CollegeMy Profile

    • I have always wondered why there are deduction limits around these investment vehicles. Shouldn’t the government want taxpayers to save as much money as possible for retirement 🙂

  10. An excellent primer on the difference between a 401k and a Roth IRA! I prefer to invest in a Roth IRA since I don’t know what taxes will look like in the future. I’ve always been a “don’t have fun now, have fun later” sort of person, so paying the taxes upfront always appeals more to me. I also like the earlier withdrawal age and that it comes with less limits. Right now I don’t contribute to a 401k, but I do plan to invest more heavily once we pay off our debts.
    Mrs. Picky Pincher recently posted…My Favorite Money Bloggers, Part 3My Profile

    • Thanks for sharing Mrs. Picky Pincher!!! I am a big fan of a Roth IRA and have been contributing since I graduated college. It’s definitely started to creep up over the years and it’s nice knowing I can pull it out tax free in a number of years 🙂

  11. We are in high tax brackets now, which is great. It means we are making good money, thanks to God. That’s why we are doing everything we can to save on taxes; we are maxing out all out pre-tax vehicles.

    In addition to that we maxing out out Roth IRA (backdoor) as well.
    Friendly Russian recently posted…A story about one financial mistakeMy Profile

    • Thanks for sharing Friendly Russian!! I am a huge fan of the backdoor Roth IRA. I’m not sure enough people know about it yet. I’m definitely trying to share as much as possible 🙂

    • I definitely agree that compounding is incredibly huge. If people would max out their 401k I can’t imagine that they wouldn’t be millionaires by the time they reach 60 if they started in their 20s.

  12. Really excellent summary! Before Mrs. Freaky Frugal and I FIREd, we only had Traditional IRAs.

    After we FIREd, our taxable income was so low that I’ve been converting some of our Traditional IRAs to Roth IRAs. I’ve actually had to do this so that I push our income up enough for Obamacare to be out of the Medicaid range.

    But it makes sense anyway since I don’t think our tax brackets can get lower and there’s a strong possibility the government will raise taxes to reduce debt.
    Mr. Freaky Frugal recently posted…Freaky Frugal or Stupid Frugal?My Profile

  13. This is a great overview! I’m a big fan of the Roth if it makes sense for your tax bracket.

    I hear Ric Edelman say all the time on his podcast how he fears the Roth will be taxed in the future. But politically, that would be very difficult to pull off if the policy includes investors with money already in Roths, since taxes were already paid.
    Mrs. Groovy recently posted…The Groovy Drawdown StrategyMy Profile

  14. Nice write-up. One thing many people forget to consider is a taxable account for retirement savings… especially someone who would like to retire early. Having a taxable investment account lets you access the money without penalty whenever you want, and the gains are taxed at a preferential rate. It’s definitely something to consider as part of the overall plan.
    Brad – MaximizeYourMoney.com recently posted…Life insurance: Options, Needs, and CostsMy Profile

    • I definitely would love to get these concepts into school. Especially when colleges are essentially signing them up for debt through student loans 🙂

  15. Thanks for breaking it down. I think along the same lines as you:
    1. 401(k) up to your company match (if available at your employer – max this out for both you and your spouse, if applicable)
    2. HSA to max (if available at your employer)
    3. Roth IRA to max (if your income is within Roth IRA parameters – max this out for both you and your spouse, if applicable)
    4. 401(k) to max
    5. Taxable (invest in a taxable account only after you max out all of your available tax shelters)

  16. Thanks for this comprehensive post about the Roth and traditional IRA. We follow the same approach that you follow. We first try to max out our traditional 403b accounts. Next, we max out the Roth IRA accounts. Lastly, we contribute to our taxable accounts. This approach will give us easy access to our money in FIRE and diversity our tax strategy along the way.
    Dave recently posted…The Power of a Dual Income CoupleMy Profile

  17. Nice summary! I agree with your conclusions regarding the 50/ 50 split. My husband and I both contribute to Roth 401K accounts and then separately to traditional IRA accounts. I think the mix between the two account types is the best of both worlds. This year our goal was to max out our IRA’s ($5,500 each). Next year our goal will be to max out our 401K and IRA’s! Thanks for the great summary 🙂
    Courtney @ Your Average Dough recently posted…1 Million Ways to 1 Million Dollars: InvestingMy Profile

  18. This is a terrific write up to have all in one place!!! Half of these concepts (when I was trying to figure it out) I had to Google 15 different times. I wish I knew the PF community existed when I was younger, this stuff is so important. But Google spits back the top page as the IRS website with their miserable complicated lingo.

    I’m still not understanding how AGI (or MAGI?..is that even the same thing?) is calculated.

    Oh my god I hate taxes! This is why I leave all the tax stuff for my husband. We haven’t even gotten to the mega backdoor yet.

  19. I wish you had written this post several years ago when I was trying to decipher the difference between all these accounts! I’m fortunate to have a 401k through my employer, but my husband isn’t so lucky (I guess we fit the 1 in 2 statistics). When we started investing towards our retirement in a few years ago (sadly we missed our 20s due to grad school and starting a business), we also were putting money into Roth IRAs. However, as we have moved up in the tax bracket we have switched to Traditional IRAs. Once I leave my full-time employment, we may switch back to Roth IRA. I’m intrigued by the possibility of using a Roth conversion ladder, but we’ll see if that works out in the future. We recently bought our first investment property and may pick up another one or two. So are plan is to use that income to help us mind the gap if my husband and I both decide to leave the traditional working world before we can tap into our non-Roth retirement accounts penalty free.

    • Thanks for sharing!!! I definitely wish at times I had started writing earlier on 🙂 Sounds like you have some awesome plans with the money and it makes a ton of sense with your retirement accounts.

  20. Great summary! We have contributed to both types since my company offers a Roth 401. One thing that can make a difference between if pre- or post-tax is better is non-refundable tax credits. If you contribute “too much” to a pre-tax account, you won’t use up all the tax credit because your income will be driven down to a lower tax level. This also affects what effective tax rate you are in now compared to retirement. I created a series of graphs that show how tax rates change with the child tax credit to help determine if a Roth or traditional is better in a pot a while back http://www.marriedandharried.com/optimize-roth-co…child-tax-credit/

    • Hi Emily…great point with the 8606. From what I understand the reason the backdoor Roth works is that right after you open it, your basis in your nondeductible IRA is exactly equal to its value. As a result, when you convert the nondeductible IRA to a Roth IRA in the second step of the process, Form 8606 will give you the result that none of the conversion is taxable.

  21. Very nice summary here! I do 50/50 for the exact reason you mentioned – to hedge for taxes. Also, it forces me to use both traditional and Roth accounts to save since I have both of them open. It’s good to open an account because you know it’s there and will whisper in your ear …….feed me 🙂
    SMM recently posted…Simple Stock Comparison – KO & PEPMy Profile

  22. Hi, great summary. I’d like to add another alternative for a tax-deferred account. The third layer of maximizing employer/employee pre-tax contributions is to enter in a Health Savings Account. If you are a good fit for this type of medical insurance, it offers generous benefits.
    https://www.irs.gov/publications/p969/index.html

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