Financial Planning: Roth IRA vs Traditional IRA vs 401K

Saving for retirement utilizing retirement plans can be confusing. Let’s discuss my philosophy on using a Roth IRA vs Traditional IRA vs 401K. I understand there isn’t a one size fits all for everyone, but I consider myself an average person as it relates to income and retirement. I will review each of these options and then get into the strategy that works best for me. Henceforth, when I discuss income limits I am referring to MAGI (modified adjusted gross income). MAGI is essentially income after exempt income or further deductions. For most people a rough estimate can take your gross income minus the standard deduction. The standard deduction in 2022 is $12,950 for singles, $25,900 for married couples, and $19,400 for head of household.

1) 401K

If your company offers a 401K it can be a beneficial tool for you. First, the 401K contribution will reduce your tax liability by the amount you contribute. You are able to thus defer taxes until you withdraw the principal and earnings. Second, as of 2022 you can contribute up to $20,500 per year if you are under 50 years old. If older than 50, you can contribute an additional $6,500 in “catch-up” contributions. Lastly, if your company provides a match to your 401K, that is free money.

Disadvantages of a 401K include the number and amount of fees charged. These vary by plan and many are hidden in fine print. The number of investment options are almost always very limited to a few mutual funds. You don’t have a lot of control over how your money is being invested. Another disadvantage is you cannot access these funds until age 59.5 without a 10% penalty plus regular taxes. Finally, it may not always be an advantage to defer taxes. Tax laws change regularly so you could end up in a higher tax bracket at the time you withdraw the investment.

2) Traditional IRA

The ways in which you can best utilize a traditional IRA depend on several factors. First, are you also covered by a 401K or other retirement plan at work? If you or your spouse don’t have a retirement plan at work, then you are eligible to take a tax deduction up to you full $6,000 contribution limit. If you are over the age of 50 then you can contribute another $1,000. Let’s say you do have a retirement plan at work then you can deduct the full contribution amount up to certain income limits. If you are single the income limits are $68,000, married then it is $109,000. There is also a partial deduction based on phased out income limits up to $78,000 if single, and $129,000 if married filing jointly.

I am not going to get into the details of the phase out but you can go to the IRS website or I found a great calculator at TIAA (see below).

https://www.tiaa.org/public/calcs/ira-contribution-eligibility

One last scenario to consider would be where your spouse has a retirement plan at work and you do not. In this case, the income limits are for a full deduction are up to $204,000 with a phase out up to $214,000.

Regardless of which of these scenarios applies to you, you will be able to have the investment grow tax free until you withdraw the funds. At that time, you will pay according to the current tax bracket you fall under. You cannot withdraw the funds before the age of 59.5 or you will have to pay an additional 10% penalty.

3) Roth IRA

A Roth IRA is similar to a traditional IRA in that the contribution limit is $6,000 or $7,000 per year if you are over 50 years old. You also cannot withdraw funds before the age of 59.5 without incurring a 10% penalty. The money is invest after tax and both the principal and earnings grow tax free until withdrawn. The income limits for tax deductions are also different. The income limits for a full tax deduction is $129,000 for singles and $204,000 for married couples filing jointly. The phase out range for singles is $129,000 to $144,000 and for married filing jointly it is $204,000 to $214,000 per year.

Strategies to employ

There are several strategies that I have used when comparing a Roth IRA vs Traditional IRA vs 401K.

A) Maximize the company match

I always contribute to my 401K up to the company match. For example, if my company matches 100% of the first 3% contribution of my salary, and 50% between a 4% and 5% contribution then I am going to contribute 5% to get a full 4% match (.03 + .005 + .005). This is money that is basically earning 80% on your investment, so don’t pass that up.

B) Contribute the max on a Traditional IRA if you don’t have a 401K

This doesn’t apply in my situation, but it would always be wise to take the tax break from a traditional IRA up to the max if you don’t have a 401K. Again, the max contribution per individual is $6,000 per year unless you are over 55 and then can contribute $7,000 per year. If you have a 401K and your income is below the $78,000 per year as a single or under $$129,000 then contribute to the traditional IRA up to the maximum available as well.

C) If you have a 401K and your income is over the IRS thresholds, contribute the max to a Roth IRA

A Roth IRA is a powerful investment tool as it grows tax free. You can access it penalty free once you are over the age of 59.5. With the uncertainty of the stock market it seems more like gambling to me these days. What I am doing is using a self directed Roth IRA to invest in crowdfunding real estate. See my article on that in the below link. I personally have enjoyed using Fundrise.

D) If you leave your company and have a 401K transfer it to an IRA

As I previously mentioned, 401K’s have a lot of fees and limited investment options. Transfer your money without paying taxes or penalties to an IRA to avoid these fees and give you more control over your retirement account.

E) Additional Considerations

I personally work a lot of side gigs that are 1099 or earn income that require me to pay taxes at the end of the year. If I start to earn an excess amount of 1099 income then I will start investing more in my 401K. Don’t do this until you have invested the max in the IRA’s. I try to avoid investing any more than I have to in a 401K due to the aforementioned drawbacks.

Outside of retirement accounts I would never invest in a brokerage account for stock investing. I prefer to diversify into alternative investments such as real estate. Besides real estate crowdfunding, I am now looking at investing in mortgage notes. Stay tuned as I will have a blog post on this coming soon!

www.financecoachonline.com