401K or IRA? ROTH or Traditional?

When it comes to my 401k or IRA, is a ROTH or Traditional best for me?

I believe before you jump into any financial transaction, whether that is an investment?or a purchase, you need to understand what your money is being put towards.?

Many people don’t understand that the four options above even exist.??Wait, there are four options above? Yes…

What is an IRA or 401k and what is the difference??

And then after that, what do you mean by Traditional or ROTH??

Let’s start here.?

Many companies offer both a Traditional 401k and a ROTH 401k. You can choose between either or divide a % of your investment into both if you so choose.?

The same goes with IRA’s. There is a Traditional or ROTH option.??

[IRA stands for Individual Retirement Arrangement (or some use Account)]

IRAs are available to anyone who makes taxable income. You can open these at most financial institutions or investment brokers in the US and they contain 1000’s of options to invest in. These are not through your company.?

If you file a joint return, you may be able to contribute to an IRA even if you didn’t have taxable compensation as long as your spouse did. Each spouse can make a contribution up to the current limit; however, the total of your combined contributions can’t be more than the taxable compensation reported on your joint return.

In 2022 you are able to invest up to the $6,000 limit per person. So, you and your spouse can both contribute $6,000 as long as you have made over $12,000 in taxable income that year.?

In order to invest in a 401k, you have to work for an organization that offers this investment tool to you as an employee. Many government agencies offer a 403b which is basically the same as a 401k. But for this discussion we’ll just deal with the 401k. Most 401ks have limited options (10 to 30 or so) to invest in that your company chooses for you.?

There are two options in 401ks, Traditional and ROTH. Many companies only offer the Traditional, but over the years many have started to offer the ROTH as an additional option for their employees.?

In 2022 you are able to invest up to $20,500. This does not include the company match (great news!).?

So many options! It’s like going to the food court at the mall when you’re hungry!?

Traditional or ROTH?

The main thing to understand is that the difference in a Traditional and ROTH is how taxes are handled. Think of these two terms as a first name. There is the Traditional 401k and Traditional IRA. There is also the ROTH 401k and ROTH IRA.?

Traditional?= You do not pay taxes on the money that you contribute to your investments at the time of investment. You are charged taxes when you withdraw the money from your account, both your contributions and the accrued money over the life of your investment.?

Example: You contribute 10% of your $1,000 check this pay period to your 401k. You will contribute $100 to your 401k and only pay taxes on $900 ($1,000 - $100) this pay period.?

ROTH?= You pay taxes on the money that you contribute to your investment for that year. Then, you will not pay any taxes on the money the account accrues over the life of the investment.?

Example: You contribute 10% of your $1,000 check this pay period to your 401k. You will contribute $100 to your 401k and pay taxes on $1,000 this pay period. Then, you are not taxed on any gains that $100 makes over time.?

Now, this is really where the decision becomes a big one for your future self.?

You may read the example above and think, “I’d love to delay paying taxes on this money.” But, that would be short sided.

Let’s play this out in a scenario that makes you see the financial impact of choosing the ROTH option:

• Let’s say you make $70,000 per year for a 30-year period. No raises, just flat $70k per year.?
• You determine to pay 10% of your income to your 401k = $7,000/year.?
• You are in a 25% tax bracket for this example. (25% of $7,000 = $1,750)
• Let’s also assume you will make 10% annual return on your 401k?

With a Traditional 401k:

• You’ll save $1,750 in annual taxes?
• Your 401k will have $1,266,603 in your account after 30-years. (Assuming no company match)?
• You’ve paid $0 in taxes on this money so far.?
• You would owe $316,750 in taxes once you pulled the money out if you pulled it out all at once.?

With a ROTH 401k:

• You would pay $1,750 in annual taxes over the 30-year period on the $7,000 income you directed to your 401k.?
• So, you’d end up paying $52,500 in taxes over the 30-years. ($1,750 x 30 years)?
• Your 401k will have $1,266,603 in your account after 30-years. (Assuming no company match)?
• You would owe $0 in taxes on this money at retirement.?

So, in this scenario, deciding to invest in a ROTH 401k is a $264,250 decision ($316,850 - $52,500). In the end, you get to keep that amount more of your investment.?

This is a $264,250 decision!

And what are you gaining by investing in the Traditional? You’re getting to keep $1,750 every year.?

Is that worth it? That’s for you to decide.?

One thing to also note: Your company match automatically goes into the Traditional option even if you select 100% of your 401k to go into the ROTH option. You are able to contact your financial institution and have them roll that portion into the ROTH each year but you will pay taxes on that money.?

Once you decide Traditional or ROTH, you also need to decide whether to invest in the IRA or 401k or both.?

Many financial advisors would advise the below recommendations: (we’ll assume you want to invest 10% of your income into retirement)

1. Take the company 401k match first. If your company matches 3%, your first 3% should go to the 401k. Why? Because you get 100% return on your investment right away. That’s a great deal!?
2. Secondly, put up to the limit into an IRA. This comes down to options. With an IRA you get a lot more options as to where to invest your money vs a 401k. [Note: If you are happy with your company’s 401k options and they perform at a high level compared to the market, for simplicity, feel free to invest it all in the 401k]
3. If the 3% + the IRA is still under 10% of your salary, then you would invest the rest in the 401k.?

I hope this helps simplify these decisions!?

Bottom line- the worst thing you can do is to not invest in your future self and not invest in retirement savings. Allow these two tools to work for you over time and retire with a great amount of money.?