Know Your Retirement Investment Options: 401(k) vs. Traditional IRA vs. Roth IRA

by Spero Financial

Financial Coaching icon

When saving for retirement, is it better to invest your hard-earned money in a 401(k) account, a traditional IRA, or a Roth IRA? Perhaps you’ve asked yourself this question before, or maybe you’ve never given a moment’s thought to their differences. Either way, the answer may not be quite as straightforward as the question makes it sound. As with most things in the financial world, investment advice rarely features a single, clear-cut solution. In this post, we look at some of the benefits and differences of the three most popular retirement options: 401(k) accounts, Traditional IRAs, and Roth IRAs. But first, the basics.

Diversification is the Key: Plan for both short-term and long-term savings

While saving money for retirement is critical to your financial stability later in life, it’s essential to structure your saving strategy to provide a balance of short-term savings and long-term investments. Placing your money in a traditional savings account may offer a lower interest rate than a long-term investment, but it provides greater liquidity, which means quick, penalty-free access to your money if you need it. These savings are important, but building a large savings account doesn’t necessarily count as retirement planning.

Since they are designed to allow your money to earn interest over time, retirement investments include rules and regulations that reward you for long-term planning and make it costly to withdraw contributions earlier than anticipated. If you place your money in a 401(k), you will incur a financial penalty if you withdraw your money before the age of 55. With Traditional IRAs and Roth IRAs, 59½ is the earliest age you can withdraw without penalty. If you’re planning to invest in any or all of these accounts, it’s best to invest money you can afford not to touch until retirement.

401(k), Traditional IRA, or Roth IRA — Which Retirement Plan is Best for You?

After you’ve determined how much to save in short-term savings accounts and how much to invest in long-term retirement accounts, it’s a good idea to know which products will help you maximize your money. While investment laws and regulations can be incredibly complicated, the following overview should help you gain a basic understanding of three of the most popular retirement savings options on the market today.

401(k) Overview and Benefits

Formal definition: A 401(k) plan is a qualified retirement plan that gives employees the ability to save money for retirement on a tax-deferred basis. Sponsored by employers, a 401(k) allows eligible employees to designate pre-tax funds to be deducted from their paycheck and deposited into a company-managed investment fund. Employers may elect to offer a matching program wherein they make contributions to the account based on a percentage of employee funds invested.

Real world translation: Offered by employers, a 401(k) savings plan allows employees to set aside and invest money from their paycheck before taxes are taken out. To incentivize workers to save, many employers also offer to match the employee’s contributions up to a predetermined level. Since funds are automatically set aside before taxes are taken out, saving is effortless, and believe it or not, your paycheck doesn’t drop by as much as you’d think. (e.g., If you direct $300 to your 401(k) each month, your paycheck might only go down $250 because you didn’t have to pay taxes on the $300 savings.) Together with the employer-match programs, pre-tax savings can make it feel like you’re getting free money!

Who it’s for: If you work for an employer that offers a 401(k) plan—especially one with an employer match, you owe it to yourself to take advantage of it. Even if you only manage to save 5-10% of your earnings, the tax-deferred growth alone makes a 401(k) too good to pass up. If your employer offers a matching program and you choose not to participate, you’re leaving money on the table.

Benefits of a 401(k): By automatically depositing pre-tax earnings from an employee’s paycheck into an established account, an employer-sponsored 401(k) plan provides a convenient entry point for retirement savings. The optional employer-match provides an additional return on investment on top of any dividends earned.

Traditional IRA

Formal definition: A Traditional IRA, or Individual Retirement Account, is a specialized savings account that gives individuals the ability to set aside pre-tax income and invest it on a tax-deferred basis. Invested funds are not subject to income or capital gains taxes until they are withdrawn. Due to the account tax considerations, funds deposited into an IRA may be tax-deductible and contribution limits apply.

Real world translation: While there are multiple IRA types, the Traditional IRA is a popular investment account that allows individuals to save money for retirement before it’s taxed and control how the funds within the account are invested. If you open a Traditional IRA, it is your personal account, which means you can determine your own investment strategy. Depending on your investment goals, you can decide whether to keep your IRA with a bank, a credit union, or an investment firm. Like a 401(k), the funds in the account are taxed only when they are dispersed.

Who it’s for: While IRAs are generally a wise investment option, a Traditional IRA makes the most sense if you think your current tax rate is higher than what it will be when you retire. As a general rule, Traditional IRAs are an excellent option for investors who can afford to let their money remain in the account until at least the age of 59½, as disbursements before that age incur a 10% penalty in addition to being taxed as income.

Benefits of a Traditional IRA: By investing pre-tax money in a Traditional IRA, you can reduce your current tax bill, allow your investments to grow tax-free, and pay income taxes only when you withdraw funds during retirement.

Roth IRA

Formal definition: Similar to a Traditional IRA, a Roth IRA allows individuals to save and invest money for retirement. The primary difference between the two accounts lies in the way funds are taxed. While Traditional IRA contributions can be invested on a pre-tax basis, Roth IRA funds can be invested after standard income taxes have been taken out. Because Roth IRAs investments are comprised of after-tax funds, account holders can make tax-free withdrawals during retirement.

Real world translation: When compared to Traditional IRAs, Roth IRAs are the same, but different. What does that mean? It means that while the investments in the account can be managed much the same as a Traditional IRA, Roth IRA contributions are made on a post-tax basis. Because you’re investing funds that have already been taxed, you won’t have to pay taxes on the money when you withdraw it in your retirement.

Who it’s for: Since contributing post-tax money allows investors to pay current tax rates and withdraw funds tax-free when they retire, Roth IRAs are ideally suited for investors who believe their tax rate at retirement will be higher than their current tax rate.

Benefits of a Roth IRA: Unlike 401(k) accounts, Roth IRAs boast more flexible terms that allow for penalty-free withdrawals before the age of 59½ as long as the funds are used for purposes that meet specific requirements.

Find an Investment Advisor You Can Trust

When planning your retirement, there are many factors to consider. How soon should you start saving? How much should you set aside? Are there limits to how much you can invest? Do you even qualify for specific investment options? Spero can help you answer those questions and more. We can also work with you to develop a retirement investment strategy to meet your individual goals.

When you open a retirement account with us, you can take advantage of the lower fees and competitive interest rates offered through credit unions as compared to banks and brokerages. Stop by one of our branch locations or call us today to start planning the kind of retirement you deserve!

Find Financial Freedom Through Better Banking.

Join today, and start enjoying all the benefits of membership!