What is a 401(k)?

A 401(k) is a retirement account offered usually by your employer. It’s like a VIP ticket to retirement savings, because your employer sets it up and may even contribute money to match what you save. You can contribute money to a 401(k) directly from your paycheck, before taxes are taken out. What this means is that you’re saving on taxes now, but you’ll pay taxes on the money when you withdraw it later during retirement.

Let’s say you earn $50,000 per year and decide to contribute 10% ($5,000) to your 401(k). That $5,000 goes in before taxes. You’ll only pay income tax on the $45,000 you took home, so you’re getting a tax break today. However, when you withdraw from your 401(k) in retirement, that’s when Uncle Sam will come knocking for taxes. Here are the key benefits of a 401(k):

• Employer Matching: Many companies match your contributions up to a certain amount. That’s free money, so take advantage of it!
• Higher Contribution Limits: You can contribute more to a 401(k) compared to IRAs. In 2024, you can contribute up to $23,000 per year (plus catch-up contributions if you're over 50).

What is a Traditional IRA?

A Traditional IRA is a retirement account you open on your own. It’s like a savings account but with some tax perks. Just like a 401(k), you contribute pre-tax dollars, meaning you don’t pay taxes on the money now but will when you withdraw it in retirement.

Let’s say you put $6,000 into a Traditional IRA. This reduces your taxable income by $6,000 for that year. If you were making $60,000, you’d only pay taxes on $54,000. However, once you start pulling the money out in retirement, you’ll pay taxes on both the contributions and any investment growth. Here are the key benefits of a Traditional IRA:

• Tax Deduction Now: Contributions to a Traditional IRA can reduce your taxable income today.
• Investment Flexibility: You can choose from a wide range of investments, like stocks, bonds, and mutual funds.

What is a Roth IRA?

A Roth IRA flips the tax benefit of a Traditional IRA. You contribute after-tax dollars, meaning you don’t get a tax break now, but you won’t have to pay taxes when you withdraw the money in retirement.

Imagine you put $6,000 into a Roth IRA. You won’t get any immediate tax benefit because you’ve already paid taxes on that money. But the big advantage is that when you retire, you won’t owe any taxes on withdrawals—not even on the investment gains. So, if your $6,000 grows to $20,000, you can withdraw it all tax-free. Here are the key benefits of a Roth IRA:

• Tax-Free Withdrawals: You don’t pay taxes when you take the money out in retirement.
• No Required Minimum Distributions (RMDs): Unlike Traditional IRAs, you’re not forced to start withdrawing money at age 73.

Quick Comparison Table: 401(k) vs. Roth IRA vs. Traditional IRA

Which One Should You Choose?

Choosing between a 401(k), Roth IRA, and Traditional IRA depends on your financial situation and future tax expectations. Here are a few things to think about:

• If your employer offers a 401(k) with matching: Start there! Contribute enough to get the full employer match (it’s essentially free money), then consider other options if you have more to invest.
• If you expect to be in a lower tax bracket in retirement: A Traditional IRA might be your best bet. You get a tax break now, and since you’ll be taxed on withdrawals later, paying less in retirement could work in your favor. You'll likely be in a lower tax bracket if you expect to live on less money in retirement, like from Social Security, savings, or pensions, compared to your current job income. If you plan to have fewer expenses (like paying off a mortgage), you might not need as much income.
• If you expect to be in a higher tax bracket in the future: Go with a Roth IRA. You pay taxes now, but your future self will thank you when you can withdraw everything tax-free. You might be in a higher tax bracket if you expect to earn more money in the future, or if your investments and retirement savings grow a lot.

A good rule of thumb is to think about how much income you'll need in retirement and compare it to what you're earning now. If you think you'll need a lot less, you may be in a lower tax bracket. If you expect to have similar or more income, you might be in the same or higher bracket.

Final Thoughts

Deciding between a 401(k), Roth IRA, or Traditional IRA doesn’t have to be confusing. It’s all about understanding when you want to pay taxes—now or later—and how much flexibility you want with your investments. If you have access to a 401(k) with employer matching, start there, and then explore opening an IRA if you want more options or tax benefits down the road.

No matter which option you choose, the key is to start saving. The earlier you start, the more time your money has to grow!