When I got my first “real person” job in my early 20s, the human resources director at my company went over the new employee packet so quickly it made my head spin.
When she got to the part about the company’s 401(k) options, my eyes glazed over.
401(k), IRA, Roth — what does this alphabet soup mean?
We found out so you won’t have to wonder anymore.
What is a 401(k)?
The most important distinction is that a 401(k) is sponsored by an employer, so if you’re not working, you can’t sign up for one. Your employer usually works with an investment company to administer the account.
Some employers will offer a 401(k) match, which means that if you contribute a certain percentage of your paycheck to your account, they’ll add an equivalent amount — this is a huge perk!
Most 401(k) accounts offer mutual funds, which are composed of stocks, bond and money market investments.
Your employer may make you wait a while before giving you access to money in your 401(k) account, a process known as vesting. You can begin making contributions immediately, and your employer will, too — you just can’t access your employer’s contributions for a certain period of time.
However, the money you contribute is always yours, and once you’re fully vested, any money in the account is yours — you can take it with you if you leave the company. Here are a few options to help you decide what to do with your 401(k) if you’re planning on changing jobs.
A 401(k) account is tax-deferred, meaning you can invest part of your paycheck before taxes are taken out. You do, however, have to pay taxes on the money you take out of this account.
“In a traditional 401(k), you get an immediate tax break,” said Aldo Waker, a personal finance and retirement advisor for Waker Financial in Austin, Texas.
“So, if you make $50,000 and you contribute $5,000, you will only be taxed for wages of $45,000. That $5,000 will grow over time and when you are ready to make a withdrawal, you will then pay income tax on the amount you withdraw.”
As an individual, you can contribute up to $18,000 in pre-tax money per year to your 401(k). The total annual contribution to your account, which also includes money deposited by your employer, is limited to 100% of your compensation or $53,000 (whichever is lower).
If you’re 50 or older, you can make “catch-up” contributions of up to $6,000 per year on top of the $18,000 limit, so your total annual contribution limit is $59,000.
The IRS also lets you make after-tax contributions to your 401(k), which is how you can reach those annual contribution limits.
If you withdraw money from your 401(k) before you reach the age of 59 1/2, you’ll pay a 10% penalty. Some exceptions apply, such as medical expenses or if you’ve been called to active military duty.
A 401(k) also requires you to start taking annual distributions — known as required minimum distributions (RMDs) — at the age of 70 1/2. The IRS has a nifty required minimum distribution calculator here.
The IRS created this rule so that savers would begin paying taxes on the money they’ve been socking away for decades.
Some plans let you borrow up to 50% of your vested account balance, up to a maximum of $50,000. You must repay the loan within five years.
What is an IRA?
This type of retirement account is technically called an Individual Retirement Arrangement. If your employer does not offer a 401(k) or you aren’t working (calling all students and stay-at-home parents!), then an IRA is the account for you.
Like a 401(k), an IRA offers an immediate tax break — you’re taxed when you withdraw the money, not when you put it in.
The contribution limit for an IRA is $5,500 per year, which is much lower than a 401(k). When you turn 50, you can contribute up to $6,500 per year to give yourself an extra cushion before retirement.
Most IRA providers do not require you to have a minimum amount of money to open an account. However, some mutual funds have minimum purchase requirements, usually between $500 and $1,000.
Like a 401(k), the IRS charges you a 10% early withdrawal penalty for distributions before the age of 59 1/2. The IRS does offer some exemptions from this penalty, such as paying for college, buying your first home or covering certain medical expenses.
With an IRA, you can choose any investment company you want. You can also choose to invest your money in mutual funds, individual stocks, bonds and annuities.
What is a Roth?
A Roth is a type of 401(k) or IRA. (The ones we discussed above are traditional versions of those two accounts.)
Like the traditional 401(k), a Roth 401(k) is only an option if your employer offers it. There are no income limits on a Roth 401(k).
Nearly anyone can open a Roth IRA, which does have an income limit. If you’re single and you make more than $132,000 a year ($194,000 if you’re married), you aren’t eligible for a Roth IRA.
With Roth accounts, you don’t get an immediate tax break — you’re contributing money you’ve already paid taxes on. Instead, you get a tax break when you take money out of the account.
If you contribute $5,000 at the age of 25, that money will most likely double or triple by the time you hit retirement — and you won’t pay taxes on those investment earnings.
The contribution limits for a Roth IRA or Roth 401(k) are the same as their traditional counterparts — $5,500 for an IRA and $18,000 for a 401(k). All the catch-up allowances apply as well.
A Roth IRA has no mandatory distribution requirement, unlike a traditional IRA, which requires you to withdraw money once you reach age 70 1/2.
If you are over 59 1/2, you can withdraw as much as you want from your Roth IRA or Roth 401(k) without paying taxes. Your money must have been in your account for at least five years to withdraw it without penalty.
Which Account is Right For You?
Advisors agree: If your company offers a 401(k) account and will match your contribution up to a certain percentage, you should take advantage of this perk first.
Beyond that, there’s no one-size-fits-all answer — advisers will tell you that it depends on your personal situation.
Some advisers say it’s best to first contribute to your traditional 401(k) enough to capture the employer match. Then, consider opening a Roth IRA and contribute the maximum amount. Finally, go back to your 401(k) and contribute there until you max it out.
If your employer doesn’t offer a 401(k) match, it’s really up to you to decide how you want to save for retirement.
Some of your strategy may depend on the investment options available. Since your employer offers your 401(k) account, your investment options may be more limited there than with a traditional or Roth IRA.
You should also compare plan fees — which account costs you the least amount to save?
It also depends on whether you want tax savings today or at retirement. Having both traditional and Roth accounts reduces some of the tax burden when you retire.
Another thing to consider: Your saving style.
Employer-sponsored 401(k) accounts are the easiest way to save for retirement. Because 401(k) contributions are taken right out of your paycheck, you never see that money as spendable. This kind of automatic contribution can be good for people who have a hard time saving money.
Some traditional and Roth IRAs let you make automatic contributions from your bank account, but for some people, making contributions directly from your paycheck — before the money ever hits your bank account — is the best option.
If you don’t have access to a 401(k), you’ll need to decide between a traditional IRA and a Roth IRA. To help clients make that decision, Tina Powell, chief executive officer of New Jersey-based investment firm SheCapital, said she asks them to consider their age and their income.
If you expect to earn more money later in life than you are now, a Roth may be a better fit, as you’ll pay income taxes only on your (hopefully) lower, early-career salary, Powell said.
However, if you need an immediate tax break, a traditional IRA may be a better option.
Of course, don’t just take our word for it. There are pages and pages of rules related to each type of retirement account described above, so consider working with a financial planner to make the best plan for your future.
No matter which account you use, experts say start early.
“What’s really important for young people is to save for retirement, period,” Powell said.
Your Turn: Which type of account are you using to save for retirement? Why did you choose it?
Sarah Kuta is an education reporter in Boulder, Colorado, with a penchant for weekend thrifting, furniture refurbishment and good deals. Find her on Twitter: @sarahkuta.