Roth IRA 401K

Roth IRA vs Traditional 401k: Which One You Should Choose?

What is better to invest in, a Roth IRA or traditional 401K? Now, this has a complicated answer. It’s definitely not a one-size-fits-all approach. So I figured I make this post to break down exactly which one would be best for you.

What is better to invest in, a Roth IRA or traditional 401K? Now, this has a complicated answer. It’s definitely not a one-size-fits-all approach. So I figured I make this post to break down exactly which one would be best for you.

In this post we’ll figure out which one will give you the most amount of money depending on your situation.

Roth IRA

What is a Roth IRA?

It’s a retirement account where you can contribute and invest up to $6,000 per year with post-tax money. And after the age of 59.5 you can withdraw all of that money in that account and whatever profit you made completely tax-free.

This means that you could potentially get decades upon Decades of compound interest in growth or hundreds of thousands of dollars in profit without paying any taxes on those gains.

The benefits

Some of the benefits of doing this:

First, as I just mentioned, all the profit you make is completely tax-free after the age of 59,5. That can save you a lot of money by the time you retire. Especially, if you begin investing in this early on.

Second, with a Roth IRA, you can withdraw whatever money you contribute to that account at any time completely tax-free without paying any penalty.

This means that if you contribute $6,000 to an account this year. And let’s say next year it grows to $7,000. Well, you can still withdraw your initial $6,000 without paying any additional tax. But you must however leave the profit you made in the account.

This gives you a lot of flexibility in the event that you need your money unexpectedly.

The downsides

First, with a Roth IRA, you contribute with what’s called post-tax money. This is the money that you’ve made after you’ve already paid taxes on. Of course, the money that you have leftover after you pay taxes is a lot smaller than before you have the taxes taken out. So that just leaves you with less money upfront to invest.

Second, if you want to take out your profit from this account prior to the age of 59 and a half you’re going to be subject to a 10% penalty and you’re going to have to pay taxes on that money. This pretty much defeats the entire purpose of contributing to a Roth IRA in the first place.

Third, the contribution limit to a Roth IRA is capped right now at $6,000 per year. So if you want to contribute more than that to this account, Well you can’t!

But with that said how does this all compare to a traditional 401K?

The traditional 401k

The traditional 401k is an employer-sponsored retirement plan where you contribute pre-tax money into this account. This means you won’t pay any taxes on the money that you contribute.

Now, because you don’t have to pay any tax on the money you contribute to this account you have more money left over to invest instead of paying it to the IRS. And with that extra money, you can then go and invest it to make you even more money.

Then, after the age of 59.5, you can begin withdrawing the money that you have in a 401k. And you just end up paying the taxes you would have owed later at that time.

So, basically, you’re avoiding paying taxes on that money right now just to end up paying it off later at the time you actually take it out of the account.

But the advantage of doing this is that you have more money left over upfront to invest with. So you have a larger amount working for you to make you even more money.

The benefits

Just like the Roth IRA here are the positives of doing this:

First, the main benefit of doing this is that you contribute what’s called pre-tax money. This means that this is money that has not been taxed and this is actually a pretty substantial tax write-off.

So this means for example if you’re in a 32% tax bracket. You contribute $19,000 to a traditional 401K this will save you $6,080 in taxes. This means that you have an additional $6,080. Where you can go and invest to work for you instead of paying that to the IRS.

Second, you can contribute up to $19,000 per year in a 401k. That is more than three times higher than what you can do with a Roth IRA.

Third, some employers offer you an employer-match in a 401k. This is where they match you dollar-for-dollar for whatever you contribute to this account.

In terms of investment ROI (Return On Investment), this is the best guaranteed, risk-free, 100% return investment you’ll ever get.

Always do this, no matter what at least always take the employer match.

One of the biggest benefits of contributing to a 401k is having the employer match. If you have this always take advantage of it no matter what.

The downsides

There are some downsides to a 401K that I do want to mention:

The first one is that even though you don’t pay taxes on that money now and you save all of it you’re going to end up paying taxes on that money after the age of 59.5. Whenever you take the money out of that account.

So whit a 401K hopefully you’re saving on taxes now when you’re in a really high tax bracket to then withdraw it later on when maybe you’re not making as much money in a lower tax bracket. Then you end up profiting that Difference.

Secondly, if you want to take out any of the money in a 401k prior to the age of 59.5 for anything other than financial hardship you’ll have to pay a 10% penalty plus pay income taxes on that money, which is a lot higher than you paying long-term capital gains because you’ve held that investment for a long period of time.

Third, you’ll be forced to withdraw some of this money beginning at the age of 70 and a half. This means you can’t keep it in there and let it continue growing.

Roth IRA vs 401k: Which One You Should Choose?

Now, with everything I mentioned in mind which one you should choose? a Roth IRA or a Traditional 401k.

Let’s start with a Roth IRA. Since this is done with post-tax money. Meaning you don’t get any immediate tax deduction on the money you contribute to this account.

This is best done when you’re young, in a low tax bracket, and not already making a lot of money. Or basically, it’s better when you know you’re going to be making more money in the future and because of that, you’re going to be taxed in a higher tax bracket.

On the other hand, a Roth IRA is not a good investment if you’re making a ton of money right now and you expect to make less money by the time you retire.

Let’s say that right now you’re running a business that’s making you 300k per year but you know this is not going to last forever. You don’t expect to really be making more than like $80,000 a year by the time you’re sixty.

In this case, you’re in a high tax bracket now but by the time you retire, you’re going to be in a much lower tax bracket. So in this case, it’s smarter to take the 401k deduction at the higher tax bracket and then pay taxes on it by the time you’re making less money in the lower tax bracket and you save that difference.

Of course, in my opinion, that’s really how these accounts should be prioritized. The reality is that most people in retirement will not need as much income as they need right now.

Potentially, by the time you retire, you’re going to have a paid-off home and you’re probably not going to be working full-time. Because of that, you’re not going to need as much money to survive. Then, because of that, you’re going to be in a lower tax bracket. This is ideal for withdrawing your money from a 401k when you pay tax at that time.

So for people in this position who are making a ton of money now but don’t necessarily expect this to continue in the future, a traditional 401K could make a lot of sense. Especially if you’re in a 32% or 34% higher tax bracket and you expect to retire in a lower tax bracket.

However, there’s also a very large percentage of people out there who expect to be bawling in retirement. let’s just say I expect to make more money in the future so it makes sense that I should contribute to a Roth first.

Knowing that in the future if I make more money I’m not going to have to pay any additional taxes.

Now, another concern I have with prioritizing a traditional 401K is that we have no idea what the tax situation will look like 30 or 40 years from now. For example, the tax rate could be significantly higher than what they are now.

And if this is the case, you could end up paying way more taxes in the future than if you made the same amount of money today.

I just see it as being too many variables that affect the potential tax rates positively or negatively in the future that none of us can predict.

Conclusion for Roth IRA vs Traditional 401K

So with all of this information here’s my own personal recommendation.

If you’re young and in a low tax bracket the first thing you should do is prioritize the Roth IRA. You’re not going to regret that when you’re older. Your tax-free money is going to be worth a lot more in the future.

On the other hand if you’re making a lot of money right now and you don’t expect that to last. You expect to retire in a much lower tax bracket then potentially you may want to prioritize the traditional 401K.

Take the right off money now at the high tax bracket, withdraw the money in a lower tax bracket and you’ll be left over with more in the future.

And the right mix between this, in my opinion, is probably just a balance between the two if you can of course.

You can also consider a Roth 401k. It’s similar to the Roth IRA except with a higher contribution limit of $19,000 per year. This works really well if you want more money to contribute with the Roth option beyond just a Roth IRA this one works phenomenally well.

And if you’re still confused about this topic check this calculator which will tell you how much money you would have leftover with each option for your own tax bracket and income.

Thanks for your time

This was my approach to Roth IRA vs Traditional 401k. I hope you liked it and if you did then I recommend you to join my newsletter I post about money management and how to make money online.

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