Breaking Down IRAs, Roth IRAs, 401(k)s, and Roth 401(k)s – What’s the Deal?
Saving for retirement comes in a variety of flavors.
If you’ve ever felt your eyes glaze over when people start talking about retirement accounts, you’re not alone. But understanding the differences between these options can really help you make smarter decisions for your future. So, grab your preferred beverage (and maybe a cookie), kick back, and let’s make sense of IRAs, Roth IRAs, 401(k)s, and Roth 401(k)s - in plain English!
The Basics: IRAs and Roth IRAs
An IRA (Individual Retirement Account) and a Roth IRA are both tools to help you save for retirement, but they work a little differently when it comes to taxes.
Traditional IRA: You contribute pre-tax dollars, which lowers your taxable income now. But when you withdraw in retirement, you’ll pay income taxes on those withdrawals. If you or your spouse are covered by a retirement plan at work, the deductibility of your Traditional IRA contributions may phase out based on your income level.
Roth IRA: You contribute after-tax dollars. That means you don’t get a tax break now, but qualified withdrawals in retirement are tax-free (yay for future-you!)
Contribution Limits (2024):
You can contribute up to $7,000 if you’re under 50.
If you’re 50 or older, you can add a $1,000 catch-up contribution for a total of $8,000.
Important Note: Not everyone can contribute to a Roth IRA because of income limits. For 2024, if your modified adjusted gross income (MAGI) is over $161,000 (single) or $240,000 (married filing jointly), your contribution starts to phase out. Once you hit $176,000 (single) or $255,000 (married filing jointly), you’re completely phased out. Furthermore, if you file married filing separately, like many married couples do as part of a student loan repayment strategy, you’re likely not eligible to contribute to a Roth IRA. But don’t worry, there are ways around this, like a backdoor Roth IRA.
The Workplace Giants: 401(k)s and Roth 401(k)s
These are employer-sponsored plans, and they’re similar to IRAs in concept, but they have higher contribution limits and the possibility of employer matching (more on that later).
Traditional 401(k): Contributions are pre-tax, reducing your taxable income now, but you’ll pay taxes when you withdraw in retirement.
Roth 401(k): Contributions are after-tax, so there’s no upfront tax break, but withdrawals in retirement (including growth) are tax-free as long as you’ve met the rules.
Contribution Limits (2024):
The limit for employee contributions is $23,000.
If you’re 50 or older, you can add a $7,500 catch-up contribution for a total of $30,500 for 2024, as confirmed by the IRS.
For those aged 60 to 63, the SECURE 2.0 Act introduces a special catch-up contribution starting in 2025. This amount, up to $11,250, is inclusive of the normal $7,500 catch-up contribution, significantly boosting retirement savings potential for individuals in this age range.
Employer Matching and Roth 401(k)s: Not Quite Tax-Free
Here’s a little wrinkle in the Roth 401(k): while your contributions grow tax-free, any matching contributions your employer makes are actually pre-tax. When you withdraw money in retirement, those employer matches (and their growth) will be taxed. Still, it’s ‘free’ money.
Backdoor Roth IRAs: A Strategy for High Earners
If your income is too high to contribute directly to a Roth IRA, a backdoor Roth IRA can be a game-changer. Here’s who it’s for, why it’s important, and how to do it:
Who It’s For:
High-income earners whose income exceeds the Roth IRA limits ($161,000-$176,000 for singles and $240,000-$255,000 for married filing jointly in 2024), or married couples who who file separately.
Savers looking for tax-free growth and withdrawals in retirement but are phased out of direct Roth contributions.
Why It’s Important:
A backdoor Roth IRA allows you to bypass the income limits, giving you access to the tax-free growth and withdrawals Roth IRAs offer. It’s complete, 100% allowed, despite its somewhat shady-sounding name.
It’s a way to diversify your tax strategy, especially if most of your retirement savings are in pre-tax accounts like Traditional IRAs or 401(k)s.
Steps to Complete a Backdoor Roth IRA:
Contribute to a Traditional IRA: Open or use an existing Traditional IRA and make a non-deductible contribution (up to $7,000 for 2024 if under 50, $8,000 if 50 or older).
Convert to a Roth IRA: Soon after making the contribution, convert the funds to a Roth IRA. There’s no income limit for conversions. You can do it at any age, whether you’re employed or not.
Pay Taxes (if applicable): If the contribution amount has grown before conversion or if you have other pre-tax funds in the IRA, you may owe taxes on the conversion. That's why it's important to do the conversion immediately after making the contribution! Additionally, avoid withholding taxes from the IRA during conversion. Doing so counts as an early distribution and will result in a 10% IRS penalty and federal income taxes - and sometimes state income taxes, depending on the state you live in. The whole point of doing this is to avoid taxes! It's better to pay any taxes owed out of pocket.
Document Correctly: Ensure you file IRS Form 8606 to report the non-deductible contribution and conversion.
Important Note: If you have other pre-tax (i.e. Traditional) IRA balances, the IRS uses a pro-rata rule to determine the taxable portion of your conversion. This can make the process more complex, so it’s worth consulting a financial advisor, enrolled agent (EA), or certified public accountant (CPA).
Adjustments and Catch-Ups
Every year, the IRS adjusts contribution limits for inflation. So, while the numbers for 2024 are set, they’ll likely increase over time. Catch-up contributions are another great tool if you’re 50 or older and want to save extra before retirement.
Which One’s Right for You?
It depends on your situation:
If you think you’ll be in a lower tax bracket in retirement, a Traditional IRA or 401(k) might make sense for the upfront tax break.
If you expect to be in a higher tax bracket or value tax-free growth, Roth options can be great. If you expect your income in retirement to be higher, or tax rates to increase, more Roth money will be a benefit to you.
Tax diversification can be a smart strategy. Having both pre-tax (Traditional) and post-tax (Roth) accounts gives you flexibility in retirement to pull from different buckets depending on your tax situation. In my experience, most people do end up having a mix of both.
It’s already been said, but if your employer offers a match, make sure you’re contributing enough to get it. That’s free money, and we’re not about leaving that on the table.
TL;DR:
IRAs and 401(k)s = no tax now, taxed later.
Roth IRAs and Roth 401(k)s = tax now, no tax later (except employer matches in Roth 401(k)s - assuming you’re over 59.5, and satisfy the 5 year rule (your Roth IRA, not your Roth 401(k), has to have been open for 5 tax-years. If you only have a Roth 401(k), it’s worth opening a Roth IRA now to start the clock, even if you contribute nothing to it! That way when you retire, you can roll your Roth 401(k) into it, and you’ll have full discretion over investment options - not just what your old employer dictated.)
Contribution limits for 2024:
IRAs: $7,000 ($8,000 with catch-up).
401(k)s: $23,000 ($30,500 with catch-up).
Income limits can affect Roth IRA contributions, but not Roth 401(k)s.
I hope this helps! If you’re ready to take the next step, consider scheduling a consultation to discuss your retirement strategy in more detail. Or, if you’re hungry for more knowledge, check out my blog post on Selecting Target Date Funds versus Selecting Mutual Funds. Whatever your next move, we’re here to help you make smarter financial decisions!
This content is for informational purposes only and should not be considered as financial, tax, or investment advice. Consult a qualified financial advisor or tax professional to determine what strategies may be appropriate for your individual circumstances. Investing involves risk, including the potential loss of principal. Past performance is no guarantee of future results. Contributions, limits, and tax rules are subject to change; please consult the IRS or a trusted financial professional for the most current information.
