There are several options to choose from when it comes to retirement accounts. Most notably, a 401(k), traditional IRA, and Roth IRA. While all these accounts have one common goal -- helping you save and invest money for retirement -- there are fundamental differences you should know about them. One of these differences is the amount you're allowed to contribute to the account annually.
While a 401(k) has the highest contribution limit at $20,500 ($27,000 if you're 50 or older) for 2022 , maxing out your contributions may not always be the best move for some people -- especially those who aren't in a financial position to max out all of their retirement accounts.
You can find more and cheaper investment options
Your investment options with a 401(k) are out of your control. Instead, your plan provider presents you with options, usually consisting of target-date funds, market cap-based funds, and the company's stock. While these options can be good, they are limited. Roth IRAs are like brokerage companies in that you can buy any company's stock and exchange-traded funds (ETFs).
In addition to having more options of where you can invest your money, you'll likely save money in fees with a Roth IRA compared to a 401(k). To begin, most major brokerage companies won't charge you to make a trade, and there's no ongoing fee to hold a company's stock. While ETFs do have expense ratios, they're generally much cheaper than the fund options you'll have with your 401(k), which can charge up to 2% of your invested amount.
For example, if you contribute $6,000 to your 401(k) annually for 20 years with an 8% interest rate, a 2% expense ratio would have cost you over $53,000 through that time.
You may pay more in taxes in retirement
When you make contributions to your 401(k), you do so with pre-tax money. While this is a great benefit because it lowers your taxable income, you're not off the hook completely; you'll have to pay taxes on any distributions you receive in retirement at your tax rate at the time. On the other hand, with a Roth IRA, you contribute after-tax money, so you won't owe taxes on any distributions you receive in retirement.
You may find that with a 401(k), you're paying more in taxes overall than with a Roth IRA. Yes, you technically paid taxes on your Roth IRA already, but by the time you reach retirement age, it's had time to compound tax-free. Depending on your tax bracket in retirement, you could be paying more on your 401(k) withdrawals than you did with funds contributed to your Roth IRA.
Traditional 401(k) plans also have required minimum distributions (RMD), which is money that must be withdrawn annually from your account when you reach age 72. If you don't take the RMD, you'll face a 50% penalty on the amount that was supposed to be distributed.Roth IRAs don't have an RMD; you can keep the assets in there your whole life and even pass it on to a beneficiary (although their withdrawal rules will vary).
Utilize different retirement account types
If you can afford to max out both your 401(k) and Roth IRA contributions, then have at it. Unfortunately, that's not the case for a lot of people -- especially when you consider Roth IRAs have income limits for eligibility ($125,000 for single filers and $198,000 for those married and filing jointly. If you're not in a position to max out both, you should consider focusing on a Roth IRA, as long as you're contributing enough to your 401(k) to receive the max employer match possible.
There are pros and cons to each account type, and these can benefit different people in different ways, depending on their financial goals. However, any money contributed to a retirement account is a good thing, so there's no right or wrong way to do it. As long as your setting yourself up to be financially comfortable in retirement, you're on the right path.