Planning for your retirement: Traditional IRA vs Roth IRA vs 401k

Hi all,

I have been meaning to write this post for a couple of weeks now, but just haven't had the time. The idea came from a friend of mine (shout out to Mike!) who thought it would be helpful to learn a little bit more about the differences between Traditional and Roth IRA accounts. I'm going to do you one better and throw 401k's into the mix!

I want to try and keep this as simple as possible, so I'm going to start by describing the Traditional IRA account, and then use that as a basis for comparison to explain the differences with the other types of retirement accounts.

Traditional IRA:
The idea behind the Traditional IRA account is that a person can contribute money on a deferred tax basis each year. A deferred tax basis means that, although you will eventually have to pay taxes on this money, you won't have to pay them now. The money stays in the account until your retirement, during which time it has hopefully been growing. When it is time, the money is taxed as it is withdrawn from the IRA account. Here are some KEY bullets to help further explain:

• You can only contribute a maximum of some specified amount each year. This number is constantly changing but, in 2013, it was a maximum of $5500 ($6500 for people over the age of 50).
• Once money is contributed to the account, it cannot be cashed out until age 59.5, or else you will be charged a 10% penalty fee plus taxes. 
• While you cannot cash out before 59.5, you can use the contributed funds to buy and sell investments (stocks, bonds, mutual funds, etc.) within the IRA. This is how you can potentially grow your retirement savings!
• While in the IRA account, you will not need to pay any capital gains taxes on investment gains. 
• At age 59.5, you will be eligible to withdraw your savings from the IRA without paying any penalties. The money withdrawn will be taxed based on your current tax bracket. Typically, you will be in a lower tax bracket after retirement due to a decrease in income. This is so important!!!! It means that you could potentially be paying taxes on your savings at a lower rate than you would have at the time when you contributed those funds during the peak of your career. 

Phew! Okay so that is the gist of the Traditional IRA. Now lets use this basic understanding to help shed some light on the other options out there.

Roth IRA:

The Roth IRA account is very similar to the Traditional IRA. Here are the key differences:

• Roth contributions (same maximum of $5500 in 2013) are made AFTER tax, and are thus NOT tax deferred.
• Once contributed, you can withdraw money from a Roth IRA without paying any penalty fees like you would under a Traditional plan. 
• Money generated within the plan (such as interest or stock growth) is NEVER TAXED. With a traditional IRA, money is contributed before taxes, grows throughout your career, and then both the amount you contributed, plus any growth, is taxed when withdrawn. With a Roth IRA, money is taxed when earned, then contributed, and then never taxed again. 

And that's pretty much it! Biggest difference is the timing of when taxes are paid. 

401k Plans:

401k plans are also very similar to Traditional IRA accounts. Money is contributed on a deferred tax basis, it grows throughout your career untaxed (no capital gains taxes), and then it can be withdrawn after age 59.5 at which time it will be taxed based on your current tax bracket during retirement. Here are the big differences (there are a number of big ones so stick with me here!):

• 401k's have a higher maximum contribution (in 2013, the max was $17,500 per year, as opposed to the $5500 max for IRA's). This means that you have the potential to save even more money for your retirement.
• These plans are organized BY YOUR EMPLOYER, which has a couple of different ramifications:
• The employer will often match a percentage of the employee's contribution. Meaning, if you contribute $17,500 in 2013, your company may also contribute an additional percentage of that $17,500. 
• The employer can specify (read: limit) the investments available to the employee to build and grow their savings. For some people, this could be a really positive thing. For those of you that are really confident in your trading abilities, it may feel a little invasive.
• Contributions come directly from your paycheck. With an IRA account, you are taxed on your income. Then you deposit a portion of that money into the IRA, and you subsequently receive a tax credit on the amount contributed (thus "tax deferred"). With the 401k, you are saved the trouble, as the contributions come out of your paycheck before income is taxed. 
• Finally, you have the ability to BORROW MONEY from your 401k prior to age 59.5. You will still be charged a fee on the money withdrawn; however you will pay this fee in interest TO YOURSELF. You essentially borrow the money from your own retirement plan, and then pay it back with interest. 

Okay, so that is pretty much it. Couple quick notes: 401k's also come in the "Roth" variety. They are less common (a relatively new option), and are different from Traditional 401k's in the same ways that Roth IRA's are different from Traditional IRA's. In general, the 401k tends to be the more attractive option (higher contribution maximums, employee matching, ability to borrow); however, some people would prefer the IRA options simply for the freedom to invest in whatever they choose (as opposed to the limited options of an employer organized 401k).

Now, I think that was a pretty decent description of some of the key differences between the big retirement plan options out there, if I do say so myself. Having said that, simple descriptions will not (or at least, should not) be sufficient to make an investment decision. To help those of you faced with this issue, I have included several fantastic videos below, compliments of the Khan Academy. They really break down the nuances between the three big options, and demonstrate how they would affect your savings in practice. When I first signed my job offer and began taking a look at the big boy decisions I would soon need to make, I turned to Khan Academy to help clarify my options.

I hope you have all found this helpful! Let me know your thoughts.

Traditional IRA:

Roth IRA:

401k: