What young people should know about 401(k) vs Roth IRA
If you are savvy, you'll likely pay more into these in your 20s than you'll spend on food...its worth understanding
Thinking about retirement at this age seems crazy to me. Retirement still strikes me as a funky concept…I hope I am able to align my passions with profit so I am not praying to meet age 60 to finally rest up.
Yet, you will be looked at funny by financially savvy people if you do not plop money into one or both of the two popular retirement investment accounts:
Traditional 401(k)
Roth IRA
Are people who care about these accounts dinosaurs for thinking so much about retirement? Maybe. I’ll let you decide after I lay out why these retirement funds are considered so powerful and their unique differences.
401(k): Tax Break Today, Tax Bill Later
A 401(k) is like a time machine for taxes. You delay the tax on the money you earn today for later.
Here’s how it works: you contribute pre-tax money from your paycheck into the account. This means you reduce your taxable income for the year. So, if you make $60K and you contribute $6,000 to your 401(k), you’re only taxed on $54K that year. If you’re in the 22% tax bracket, that’s $1,320 less in taxes you pay right away.
But here’s the catch: when you pull that money out in retirement, it’s taxed with the gains at whatever the tax rate is when you are old and beautiful. So if you’re pulling out of the 401(k) in retirement, and tax rates have gone up or your tax bracket has increased, you might end up paying an even greater tax.
If you are reading this, I am assuming you are financially savvy—you will have many sources of income by the age of 60 between various investments and potentially a job you love.
So, I think your tax bracket will be higher in 40 years than it is today. This is why I find Roth IRAs particularly powerful which I will explain in a moment.
What makes 401(k)’s an intuitive place to put some money in is the common employer match. Employers have different policies, but most match up to ~5-10% of what you may contribute from your salary to your 401(k).
The Upside to 401(k):
If your employer matches your contributions, you’re basically getting free money. (Read your employment contract — this is the powerful part of putting money into a 401(k) typically).
You get an immediate tax deduction.
You can contribute $23,000 annually—a lot more money than you can with a Roth IRA
The Downside:
You’ll pay taxes when you pull out the money in retirement.
You do not know what your tax rates will look like in 30 years—they could be worse.
If you pull out the money before age 59.5, it is taxed as income with a 10% penalty.
Roth IRA: Tax-Free Growth for the Win
The Roth IRA is where things get really interesting for us financially savvy folk. With a Roth, you pay taxes up front, but then all that money grows tax-free…EVEN THE GAINS ON YOUR INVESTMENTS!!
It’s like you’re paying the government to get out of your way for the rest of your life.
Imagine you contribute $6,000 to your Roth today. In 30 years, via compound interest, it grows to $100,000. When you pull that $100,000 out in retirement, you don’t owe a single cent in taxes.
If you put in $6,000 annually from ages 22-32, it could compound to nearly $400,000 by the time you are 60.
The Upside:
Tax-free withdrawals in retirement.
NO TAXES ON THE GAINS, which is huge if you’re investing in growth-heavy assets like stocks.
The Downside:
No immediate tax break.
There are income limits for contributing: if you make more than $153,000 as a single filer ($228,000 for married couples), you can’t contribute directly.
BUT, if you make more than this, you can contribute to a backdoor Roth IRA—a bit more of a hassle, but extremely powerful for higher earners.
Contribution limits are smaller than the 401(k): $6,500 in 2024 if you’re under 50.
So Which One Should You Choose?
It comes down to what kind of financial future you want. Let’s say you’re in your peak earning years, and you’re looking for a way to reduce your tax burden right now. In that case, a 401(k) might be your best bet. You get that sweet tax deduction today, plus a potential employer match. I would recommend maxing out what the employer will match at the least.
But, if you’re thinking long-term and you want tax-free growth, a Roth IRA is a great play. Plus, if you’re starting early and expect to be making more in the future (or think tax rates might go up), locking in today’s tax rate could be a smart move.
Pulling out from either before age 59.5 incurs a 10% penalty on all principle and interest. So do not put money you may need soon into these accounts. Pulling out early of a Roth will lead the earnings to be taxed as ordinary income.
Strategy: Combine Them for Maximum Power
Here’s where it gets fun. If you’re serious about building wealth for the future, the best move is often to use both accounts together. Here's how:
Contribute to your 401(k) up to the match.
If your employer is giving you free money, take it! That’s a no-brainer. Plus, you’re getting the tax deduction this year.Then, max out your Roth IRA.
If you’re not eligible for a Roth directly because of income limits (>150k), there’s a backdoor strategy to get funds into a Roth (a process known as the backdoor Roth IRA). This is ideal if you’re in a higher tax bracket and want to lock in today’s rates.Put anything left over into your 401(k).
Once you’ve maxed out your Roth, go back to your 401(k) and consider making the maximum contribution. It’s all about balancing tax benefits for today and tomorrow.
If you have other investments on the horizon like real estate, not putting all of your “saved income” (especially after you’ve maxed the employer match) into the 401(k) might be wise so it is more accessible without penalty.
A basic high yield savings account or brokerage account might make more sense for money you need to be a little more liquid.
However with a Roth IRA, you can qualify for a tax-exemption if you pull out ~$10,000 from it for a first-home purchase. To qualify for this, the IRA must have been in existence for five years.
Bottom Line
401(k)s and Roth IRAs aren’t mutually exclusive. They’re just different tools that, when used properly, can set you up wonderfully later in life. A 401(k) is great when incentivized by an employer match, but the Roth IRA is where financially savvy folks can take advantage of absurd tax-free growth for the long haul.
If you can, use both. Get the match from your 401(k), but then open up that Roth to maximize your future tax-free income.
You learning and thinking about these subjects now, due to the power of compounding, is setting you up for a fantastic financial future.
Reach out with any questions and please share this with a friend if you found any value as these pieces take me a bit to write and I hope as many people can benefit as possible!
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