Best Retirement Planning – IRA vs. 401k vs. Roth IRA

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IRA vs. 401K vs Roth IRA Retirement Withdrawals - MakeLivingGoodSo, you are planning for retirement and wondering which option will be the best – IRA vs. 401k vs. Roth IRA? Over the past 30 years, the laws have changed considerably in favor of 401K and IRA accounts which allow people like us to benefit from pretty much automatic retirement planning now a days.

If you haven’t started planning for your retirement yet, then I promise you by the end of this post, you will realize how big this mistake is to ignore retirement planning.

A simple step of investing for future can make even help us today by letting us enjoy the life and live worry free.

In this post I will also show you how IRA vs. 401K plans compare to each other and which ones are better options for you.

This post could change your life as it did mine when I started researching about this topic. So, let’s get started.

History of 401K retirement plans

Before 401K retirement plan, there used to be corporate funded pension plans.

Under a pension plan, the employees keep receiving a fixed salary even after their retirement. This continues as long as the employee is alive. Ofcourse, pension plans were not very favorable to companies as they have to set aside a large portion of their profits into employee’s pension funds. Not just companies but even for employees, it wasn’t a really good option. This is due to the fact that in order to receive pension benefits after retirement, the employee would have to stick with same employer throughout his working age. There was less flexibility for someone who wants to switch between jobs and still earn a decent retirement benefits later.

Around 1980s US companies lobbied their government to change pension laws to come up with something more favorable for corporates. The rumor is that it all started with Internal Revenue Service (IRS) which was trying to control the amount of perks given to top executives in tax deferred manner.

With invent of 401K plan, corporates could finally take a breath of relief as they didn’t have to provide salary to employees through out their life after retirement. The way a 401K plan works is that it needs to be initiated by employee and then only employer will match employee’s contributions up to a certain limits. So, it’s kind of optional retirement plan. What about retirement plans for self-employed? More on this later in the post. Let’s first understand how really a 401k plan works?

Read More: Is Knowledge really a power in Investing World?

How really a 401k plan works

Basically the 401K plan is a retirement plan that allows an employee to save a portion of his gross income tax deferred until 59 1/2 of age. Under this retirement plan; an employer will also match employee’s contribution up to a certain limit.

Let’s take an example to decode this – Say Gary earns $100,000 as gross income a year. He wants to allocate 6% of his gross income into a 401K retirement plan. His employer offered to match 50% of Gary’s contribution to 401K.

So, in this case Gary’s contribution will be $6000 a year (that’s $500 per month) and his employer’s contribution will be $3000 (50% of $6000) a year. This means, Gary will save a total of $9000 a year into his 401K retirement plan. That’s pretty sweet considering he only put in $6000. Additional $3000 was free money.


401K Tax Deduction

Another benefit of 401K retirement plans is that they are tax deferred plans meaning you pay tax at the time of 401K withdrawal not at time of contribution.

Here’s how it works. Say you got a paycheck today. Your contribution into 401k plan will be made from gross income and whatever is left, will be taxable income today.

In other words, you do not pay any tax today on contributed money but only at the time of 401K withdrawal during your retirement years. We will dig deeper into this later in the post and compare the benefits of 401K over IRA account which allows paying no tax at withdrawal on retirement.

This advantage makes retirement plans a great vehicle to get rich doing nothing.

How to get rich doing

401k Company Match

Today many corporates offer a matching contribution to their employee’s 401K plan. Even if your employer doesn’t sponsor an employee retirement plan such as 401K, 403(b) or 457, you shouldn’t be disheartened. There are many other retirement plans for self-employed individuals; such as Roth IRA or traditional IRA; which allows anyone to save for your their retirement.

In my opinion, even if your employer provides retirement planning benefits, Roth IRA or traditional IRA retirement accounts are great retirement plans for individuals.

In case your employer provides a matching contribution, then it’s like free money and you must take that offer. I highly recommend to maximize your contribution in order to take maximum benefit from it.


Maximum 401K Contribution

Even though you avail for maximum contribution rate to take benefit of your employer’s match, you can’t contribute above a limit per IRS rules.

There’s a maximum 401K contribution limit that an employee and his employer make in a financial year. According to IRS website, the limit is $18,500 if an employee is less than 50 years of age.

In case employee is 50 years or older, then he/she can contribute additional $6000 a year as a catch up amount into his 401K retirement plan.

If you are an individual earning over a million dollars, then there’s also a limit to maximum 401K contribution that an employer can match based on your salary. An employer can match up to the limit of $275,000 in gross salary of the employee.

Here’s a simple chart to revise everything we discussed so far about 401k contribution limits.

Maximum 401K Contribution - MakeLivingGood

What is a Traditional IRA

While 401k retirement plans are for employees only who can take advantage of retirement planning offered by their employers. Traditional IRA (also referred as individual retirement account) is for any individuals as long as they are under the age of 70½.

Similar to a 401K account, traditional IRA also offers tax-deferred growth on our saving towards retirement account. As in 401k retirement plan, the assets in the IRA will not be taxed until they are withdrawn. A traditional IRA may also offer tax-deductible contributions for people who don’t participate in an employer-sponsored plan.

In other words, IRA plans are open to employees as well as self-employed workers.

What is a Roth IRA

Roth IRA is a same as traditional IRA but we pay tax on income before making contribution to Roth IRA and any withdrawals in future will be tax-free.

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Many believe that paying tax in beginning is a better approach especially if you are in low tax bracket today. So you would have to pay less taxes today under Roth IRA.

We will also cover some statistics with real examples comparing each of the retirement plans later.

Can we get Rich with Retirement plan

Short answer is. Yes, we can. In fact retirement planning in 401K was one of the best ways to get rich while doing nothing as such.

Related Content

IRA vs. 401k

Although IRA vs. 401K both provide same tax advantages, but there’s a key difference in between both of the plans.

In IRA retirement plan, an employer won’t be making any contributions but only the employee will contribute. Whereas, in 401K an employer can match contribution of up to 100% of employee’s contribution.

For those who have the option to choose one of IRA vs. 401K plans then employer matching of contributions can significantly tilt the advantage toward investing with a 401k. For instance, if your employer matches 100% of your contributions, then that’s equivalent to a 100% return on investment. It would take years in an IRA to achieve that same 100% return. Over time, those contributions compound, leading to far more growth over the long-term.

Another key difference between an IRA vs. 401k retirement plan is in cost of switching.

401K plan is tied to an employer. So if an employee switches job, then he would either have to rollover his 401K to IRA account or leave it with previous employer or continue with new employer. If switched, there may be 2-4% cost incurred which could be couple thousand dollars if account is big enough.

One thing that I don’t like about 401K plans is that they offer only a handful of options to invest in while IRA is like a typical brokerage account providing much wider spectrum of investments including index funds or even individual stocks. If interested in starting IRA account today, here are some IRA account providers that offer good options today.

If you are interested in buying individual stocks with $0 transaction fee, then I highly recommend you to try Robinhood. They are great and I loved their service. If you register with my link today, you will also receive a random stock of any US company for free. Again, free money on table which smart investors never want to miss.

Traditional IRA vs Roth IRA

Both Traditional and Roth IRA are same in many ways. For instance both provide generous tax breaks. But it’s a matter of timing when you get to claim the tax benefits.

Traditional IRA contributions are tax-deductible on both state and federal tax returns for the year you make the contribution; withdrawals in retirement are taxed at ordinary income tax rates. In other words, you contribute and then pay tax on remaining amount, thus reducing your income taxes today.

With Roth IRAs, you pay the tax first and then make contributions. So, Roth IRAs provide no tax break for contributions, but earnings and withdrawals are tax-free in future.

For Parent Readers: On a side note, with retirement planning, you also need to plan for what your kids are watching on television. As its our duty to protect them from TV violence. Checkout how I am saving my kids from all sorts of TV violence.

Another major difference between Roth IRA vs traditional IRA is in withdrawal process:

  1. In Roth IRA, you can withdraw the money from retirement account when you need it for down payment on a home or paying for college. I recommend to keep it in the account if possible.
  2. In case of traditional IRA, you must withdraw a percentage of your fund at age of 70.5 years. Remember this withdrawal will be taxable as you already got tax deduction at the time of putting the money in.
  3. Roth IRA also requires us to plan first withdrawal at least 5 years after the date of first contribution. Otherwise, there will be some tax on the withdrawal amounts. There’s no such limitation on traditional IRA though.
  4. Roth IRA contributions (not earnings) can be withdrawn any time even before you are 59.5 years old without any penalties while tradition IRA imposes penalties unless the funds are used for emergencies or home purchase. After retirement, the earnings + contributions are tax-free in Roth IRA.

One strategy which is often used by early retirees is to use Traditional IRA during their working years and Roth IRA afterwards.

The idea behind this is simple. When you are at high tax levels, then use IRA because it offers upfront tax savings.

When you are retired and possibly under lower tax bracket, you move funds from IRA to Roth IRA without any taxes. This makes entire contribution and returns tax free if executed properly.

If you have 401(k) from employer, then you can switch 401k funds to traditional IRA after leaving the employer (like job switching). Then later move funds from IRA to Roth and save tax on withdrawals.

Roth IRA Contribution Limits

There are certain IRA contribution limits whether it’s Roth IRA or traditional IRA. The good news is that both have same limits in terms of amount contributed towards either of the account.

Here is the comparison chart for IRA vs Roth IRA contribution limits:

Roth IRA contribution limits - MakelivingGood

Roth IRA doesn’t have any age restrictions, but they do have income-eligibility restrictions:

  1. Single tax filers: must have modified adjusted gross incomes of less than $135,000 in 2018 to contribute to a Roth IRA. The contribution limits are phased out starting with a modified AGI of $118,000$120,000 in 2018per IRS guidelines.
  2. Married couples filing jointly: must have modified AGIs of less than $199,000 in 2018 in order to contribute to a Roth IRA; contribution limits are phased out starting at $186,000 ($189,000 for 2018).
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Here are latest IRA contribution limits.

In case of tradition IRA, anyone with an income and younger than 70.5 years, can contribute towards IRA.

Why I think Roth IRAs are the best

In Roth IRA you pay taxes upfront and can withdraw funds later tax-free. This is a big difference between Roth IRA vs. 401K or traditional IRA.

So, basically the deciding factor is the tax bracket you are in today. If you are in low tax bracket today, then paying low tax today is wiser than paying higher tax on larger amount (contribution + growth) later.

Another thing to consider is tax rate. Many people believe that income tax rates will increase in future considering high deficit in US today. So, choosing a Roth IRA account may be beneficial if tax rates are increased by government in future.

I highly recommend you to open a Roth IRA account today even if you have a 401K.

IRA vs. 401k vs. Roth IRA Contribution Limits

Here’s a quick comparison of contribution limits across all three retirement account options:

IRA vs. 401k - Roth IRA contribution limits - MakeLivingGood

Here are latest IRA contribution limits

Wealth Creation through Maximum 401K Contributions

Now let us see how anyone can create enormous wealth through his/her 401K or Roth IRA accounts automatically.

For the sake of this study, we will assume that John started making 401K contributions at 6% of gross income with 50% match up from employer.

Moreover, John’s gross salary was increasing at very low rate of 1% every year all the way to his retirement day. He didn’t take out any money out of that growth but instead he increased his 401K contribution rate by entire 1% consistently every year.

In other words, first year his contribution was 6%, second year it was 7%, third year it was raised to 8% and so on until he hit the maximum contribution limit of $18,500 per annum.

He setup his retirement account to automatically invest all contributions in an investment giving on average of 8% return a year. To make the calculations simpler; we will only calculate interest at the end of the year.

Here are the calculations year on year for John’s retirement account:

IRA vs 401K Wealth Creation - MakeLivingGood

Notice John started contributing in his 401K plan at age of 25 years when his salary was $80,000 (column A). John’s employer was matching up to 50% (column C) of his contribution (column B).

In first year, John and his employer contributed total of $7,200 which was grown to $7,776 by the end of the year. John also made contributions to Roth IRA account from post tax income (column E). His contribution was just $3,216 (column F) in first year which grew to $3,473 by end of the year after 8% return on investment.

Next year John’s income grew by 1% to $80,800 and he increased his 401K & Roth IRA contributions to 7% each and so on.

At age 40, his contributions hit the ceiling of $18,500 as the maximum 401K contribution limit allowed per IRS. So, that year onwards, his contribution was fixed at $18,500 until age 50 when he took full benefit of utilizing catch up limits of $6,000.

At age 50 onwards, his contribution was increased to $24,500 due to addition of catch up contributions. This pattern was continued until age 65 when John finally retired.

What about John’s Roth IRA Account

On the other hand, he hit the ceiling limit of $5,500 at age of 29 in case of Roth IRA. At age 50, he made use of additional $1,000 that IRS allows anyone 50 or older to add-on to their Roth IRA account. So, his contribution increased to $6,500 a year until he was retired at 65.

How much did John make

In the end, he built a corpus of $1.58 million in Roth IRA account. All of which was tax-free whereas in his 401K account he had accumulated over $4.77 million.

Even if 401K corpus is taxed at 33% in future, still John would have much more money than what he had accumulated in Roth IRA account. Part of 401K came from his employer’s contributions. This is sweet, isn’t it?

As seen here, huge amount of wealth can be created by disciplined approach of contributing to 401K retirement plan.

I highly recommend to invest in both the plans together. You should enroll in a 401k plan offered by your employer and also open a personal Roth IRA retirement account on sides.

Just keep in mind that it’s not a question of IRA vs. 401K for you; rather you should focus on building wealth by combination of two for optimal results.

On a quick side note, I highly recommend you to checkout why order of rate of returns on your investment is very critical to understand. It has power to make or break someone’s retirement corpus.

Income Tax Reduction

As we already know that 401K contributions are pre-tax earnings. So, you do not pay tax on amount invested in 401K. An interesting thing that I came to know after 10 years of my work. It came as a flash of light one day and lit my head up. I remember I got so excited that I couldn’t sleep that night.

Here’s what I learned. Suppose you are contributing 6% of your gross pay into 401K and your employer is matching up to 50% of your contributions. So, employer will match 3% of your gross pay. Now total of 9% is contributed to your 401K every year. Remember you are saving tax on 6% only.

Now you might be getting a bonus cheque at least once a year for your outstanding performance at work. Before bonus is paid to your account, 6% of this amount is also taken out and contributed into your 401K retirement account. Then on 94% of the remaining bonus amount is taxed. I found that this tax could be over 28-37% depending upon which US state you live. So, about 28-37% of your bonus actually went into taxes.

Let me illustrate it with an example

Say your bi-weekly cheque amounts to gross $4100 and you are paid a special bonus of $4500. Total is $8600. Out of this, $516 (6% of 8600) will be put in your 401K retirement account. On remaining amount $8,084 you will pay tax of about $2,264 (@28% net). You are left with $5,820 including the bonus.

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Now let’s take an example where you temporarily increase the contribution rate to 50% (maximum allowed) just before the paycheck & bonus is paid to you. In this case, your 401K contribution will be $4,300 & employer match will be same $258 (3% of $8600). Now you will be left with $3,096 after $1204 paid in taxes.

In second case, you saved about $1,060 in taxes and effectively got $7,654 compared to $6,594 in first case.

If you are 50-year-old or younger you can contribute up to 50% of your gross salary. I suggest to temporarily increase the contribution rate to maximum 50% to save tax and then before next paycheck change it back to normal rate. This money saved in tax and extra contributed in 401K will all come back to you multifold later.

You will need to talk to your benefits or HR department to change the contribution rate before pay-day. Some corporates need 2 to 3 weeks to process the change. So, do it as soon as possible.

Consequences of 401K Withdrawal

Here are some circumstances under which an employee may withdraw his 401K contributions:

  1. Separation from Employer – switching job may trigger an employee to withdraw his 401K account. I will tell you why this is a bad idea to withdraw 401K on job switching in a minute. For now, just remember that it is possible to leave 401K account with your old employer untouched and open another account with the new employer or merge two accounts together. In either case there won’t be any tax or penalties imposed.
  2. Lifetime emergencies – Although its hard to debate against emergencies.I will only say that 401K withdrawal should be the last option to go for.

What will be the effect of 401K withdrawals before retirement? Let us examine that now.

Assume that John had to withdraw $200,000 at age of 45 due to some personal reasons. For sake of simplicity, we will ignore the penalties or tax imposed for now.

This is how his net savings would look like at age 65 in this case.

401k Withdrawal - 401K Loan - MakeLivingGood-

As you notice, at age 65, his net corpus will be reduced to $3.65 million. A difference of over $1.1 million for withdrawing just $200,000 in middle of the plan. That’s a big difference from what he could get by leaving the funds until retirement.

So, its important to not touch the 401K or Roth IRA plans in middle and let the compound interest do its magic.

Again, in case of emergencies if you have to withdraw then make sure you have explored all other options and withdrawing from retirement account is the last option left.

How to Live on 401K Withdrawals

Honestly this is not easy to answer and answering it with some level of accuracy is nearly impossible. But we will consider few general scenarios to get close to the answer.

Suppose you have accumulated $4,768,105 in your 401K retirement account by age of 65 (scenario 1). Now is the time to retire and enjoy your savings. As we assumed earlier that your 401K funds are invested in a plan yielding 8% average annual returns (possible but not guaranteed; S&P 500 have given over 10% returns in last 50 years); so for first scenario, let us use same annual return on remaining amount in 401K account for rest of life.

Here’s S&P 500 annual returns since inception in 1928. The average return is close to 10%. Again, this is not guaranteed and any attempt from my side to predict the market returns in future would be an act of stupidity.

S&P 500 returns since inception - MakeLivingGood

source: macrotrends

I wrote about Why is Order of Rate of Return so Important in another post and it’s a critical way of looking at your life’s savings.

1. Withdraw at 6%, Growth at 8%

Now, suppose you decided to withdraw a fixed 6% of funds every year from our 401K plan which is growing at 8% a year on average. This is how it will look like over the years after retirement:

401k Withdrawal - MakeLivingGood

As you see, your account will actually grow faster than you can withdraw. This is due to the fact that your 401K withdrawal rate (6%) is less than the growth rate(8%).

2. Withdraw at 8%, Growth at 6%

What will happen if we reverse the scenario. Say your withdrawal rate is 8% and growth is reduced to 6% per annum. Here’s how it will look:

401k Withdrawal - IRA vs 401K - MakeLivingGood

Even in this scenario, you can live comfortably all the way until 99 years of age and still have $2 million left in 401K account. Not bad, right!!!

3. Withdraw at 8%, Growth at 1%

Now let’s assume that you are still withdrawing at 8% a year but your 401K account is growing only at 1% a year. Today CDs provide around 1% interest per annum but they are safer than stock market. Here’s how your account balance would look like throughout the years:

401k Withdrawals - 401K Loan - MakeLivingGood

In this scenario, the annual distribution will be reduced year on year and it will be hard to live on less money every year.

It is an awakening discovery indicating that one should invest the accumulated funds such as to compensate for withdrawals. If your withdrawal rate is 6%, then your investments should be at least 6% a year to enable you live comfortably for long time.

If you want to know if it’s possible to make money in stock market or not, I recommend you to check this post – Can We Really Make Money in Stock Market.

IRA & 401k Account Providers

Here are few investment bankers providing good offers on new IRA account openings.

  1. Merrill Edge IRA Retirement Account. There’s a $600 cashback offer for new accounts.

Merrill Edge Retirement Account - IRA vs 401k - MakeLivingGood

2. E*Trade offers all types of retirement accounts and it’s a must check before deciding on one.

ETrade Retirement Accounts - IRA vs 401k - MakeLivingGood

3. Vanguard is a low-cost investment services provider. You can find it here.

Vanguard Retirement Account - IRA vs 401k - MakeLivingGood

In this post – IRA vs. 401k vs. Roth IRA, we covered all you need to know about IRA, 401k or Roth IRA accounts.

I would love to know how’s your retirement plan going? Are you using 401k with IRA accounts or just one of those. Let us meet in comments below.

You have finished reading:

IRA vs. 401k vs. Roth IRA

IRA vs 401K - Retirement Planning - MakeLivingGood

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21 thoughts on “Best Retirement Planning – IRA vs. 401k vs. Roth IRA

  1. Good to know! Honestly I’m a bit behind on understanding these things. Thanks for this! x

    1. Thats great. I think you should also take benefit of Roth IRAs. Those are different retirement saving products and work great in long run.

  2. Geraline Batarra says:

    Very informative post and this must be read by all who are planning to have a retirement. Thanks for sharing!

  3. Wait, do you not get pension where you live? I’m not sure about the numbers, but in Norway we get at least 50% of our salary from when we were working in pension from the state.

    1. Hi Kate, there’s no pension in USA (atleast I haven’t heard of it). Good that you have it in Norway 🙂

  4. Surekha Busa says:

    Such a very interesting and informative post to read. I don’t have any plan to retire yet but someday I am sure that I will come on that day. For me, investing is a nice way to make your retirement money grow.

  5. Oh wow, this was a great summary about what these 401K and IRA means. I knew it was for retirement but these info helped me understand a bit better

  6. Ellie Plummer says:

    I’m still at uni but I guess it’s never too early to think about retirement, or a pension.

  7. I never realized how complicated retirement planning is for Americans. I have never worked for a company that provided a pension fund and started contributing to a private retirement annuity fund about 17 years ago. In my current job we don’t pay anything into a retirement or pension savings fund but when we leave or employer pays out an end of service benefit.

    1. I think you should also look into Roth IRA and that is something you can do on your own. It comes with a great tax benefit too. Good luck

  8. Very detailed blog post. 401K is great if the company matches otherwise a self-controlled retirement plan is better IMO.

  9. I’m all about the employer match! I mean, why leave money on the table if you don’t have to?

  10. Over the years I have had both traditional IRAs and 401k’s. This is very good information for everyone and they shoild read it. Be very careful on what they invest your money in–keep your eye on it!!

  11. I know nothing about retirement plans and sometimes I do wonder if I will ever have one. I do feel that my generation is meant to sort of like work forever, because freelancers don’t really get any pension funds.

    1. You can always have retirement planning of your own. It doesn’t have to be a pension fund. If you can invest in mutual funds or index funds in automatic regular payments then thats all you need for retirement.

  12. Monidipa Dutta says:

    This is really good and informative. You have created the article very well. Many will be benefitted from it.

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