Retirement Accounts: 401(k), IRA and Roth
Tax-advantaged retirement accounts are the main investing tool for most American households. They do not hold a special kind of investment. They are wrappers that change how your stocks, bonds and funds are taxed. The trade-off for the tax break is a set of rules about how much you can put in and when you can take money out.
Traditional versus Roth
Most account types come in two tax flavors:
- Traditional (pre-tax): contributions may reduce your taxable income now, investments grow tax-deferred, and withdrawals in retirement are taxed as ordinary income.
- Roth (after-tax): contributions get no deduction now, but investments grow tax free and qualified withdrawals in retirement are tax free.
A rough rule: if you expect your tax rate to be higher in retirement than it is today, Roth contributions tend to look better. If you expect it to be lower, traditional contributions tend to look better. Because no one knows future tax rates, many people hold some of each.
401(k) and similar workplace plans
A 401(k) is offered by an employer and funded through payroll deductions. Similar plans include the 403(b) for schools and nonprofits and the 457(b) for many government employers.
- Employer match: many employers add money when you contribute, for example matching part of what you put in up to a percentage of pay. A match is part of your pay, so contributing at least enough to get the full match is one of the most common pieces of financial advice.
- Vesting: your own contributions are always yours, but employer contributions may vest over several years of service.
- Investment menu: you choose from the plan's list of funds, often including index funds and target-date funds. Check each fund's expense ratio.
- Roth option: many plans offer a Roth 401(k) alongside the traditional version.
- Higher limits: workplace plans allow much larger annual contributions than IRAs, with extra catch-up contributions for older workers.
Individual retirement accounts (IRAs)
An IRA is an account you open yourself at a brokerage or other financial firm, so you pick from a much wider range of investments.
- Traditional IRA: anyone with earned income can contribute. Whether the contribution is tax deductible depends on your income and whether you or your spouse are covered by a workplace plan.
- Roth IRA: contributions are not deductible, and the ability to contribute phases out at higher incomes. Qualified withdrawals are tax free, and you can generally withdraw your own contributions (not earnings) at any time without tax or penalty.
- Rollovers: when you leave a job, you can usually move a 401(k) into an IRA or a new employer's plan without tax, if the transfer is done correctly. A direct trustee-to-trustee transfer is the simplest way to avoid mistakes.
Withdrawal rules to know
- Early withdrawals: taking money from a traditional account before age 59½ generally triggers a 10% additional tax on top of regular income tax, unless an exception applies. The IRS publishes the list of exceptions.
- Roth qualified distributions: earnings come out tax free if the account has been open at least five years and you are 59½ or older, or meet another qualifying condition.
- Required minimum distributions: traditional IRAs and workplace plans require you to start withdrawing a minimum amount each year once you reach an age set by federal law. Roth IRAs do not require withdrawals during the original owner's lifetime.
Limits change
Contribution limits, income phase-out ranges and catch-up amounts are adjusted by law and for inflation. Check the current figures on the IRS pages linked below before you contribute.
Once your account is open, the next question is what to hold in it. Index Fund Investing and Risk and Diversification are good places to start.
Sources
- IRS: Individual retirement arrangements (IRAs)
- IRS: Roth IRAs
- IRS: 401(k) plans
- IRS: Exceptions to tax on early distributions
- IRS: Required minimum distributions FAQs