When it comes to retirement accounts, 401(k) plans usually dominate the discussions. For many people, it's the retirement account. A 401(k) rightly earns its spotlight, but it's not the only show in town. An IRA is just as good an option -- and in many cases, it's even better.
A traditional IRA is similar to a 401(k) because contributions could potentially lower your taxable income. Whether your contributions are tax-deductible depends on your income, filing status, and whether or not you're covered by a retirement plan at work. Contributions to a Roth IRA are after-tax, but your withdrawals are tax-free in retirement as long as other requirements are met.
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More freedom with your investments
A major 401(k) limitation is the limited investment options. You're at the mercy of your plan provider's options, often limiting you to your company's stock, a handful of index and mutual funds, and target-date funds.
IRAs work like brokerage companies, allowing you to invest in virtually any stock or exchange-traded fund (ETF) you want. Having the option to invest in your favorite companies, industry-specific ETFs, and, in some cases, alternative investments ensures you can really tailor your portfolio to match your goals and risk tolerance.
This isn't to say you can't have a well-rounded 401(k) portfolio that matches your needs. You absolutely can. Still, an IRA offers a level of flexibility and control that's hard to argue against. Whether you're a value investor, growth investor, income investor, or a combination of the three, you can craft your portfolio accordingly.
Withdrawal rules are more lenient
Generally, you have to be 59 1/2 years old and have had your IRA for five years to make any withdrawals. Any withdrawals before that are subjected to a 10% early withdrawal fee and may be counted as gross income for the year.
However, there are exceptions to this rule for both 401(k)s and IRAs. The difference is that IRAs are more lenient with their exceptions. Here are some exceptions that apply to IRAs but not a 401(k):
- Education: You can use withdrawals for qualified higher education expenses
- First-time homebuyers: You can withdraw up to $10,000 for a first-time home purchase
- Medical insurance: You can pay your medical insurance premium while unemployed
With a Roth IRA, you can withdraw your contributions, but not earnings, at any time for any reason without facing a 10% early withdrawal penalty. You want to avoid withdrawing retirement funds if possible, but it's nice to have the option without paying a penalty.
Traditional IRAs and 401(k)s have required minimum distributions (RMDs) at age 73, but Roth IRAs don't. In a Roth IRA, you can let your money compound as much as you want and pass it on to a beneficiary if you choose. Not taking an RMD in a traditional IRA or 401(k) will spark another penalty.
Choosing between a Roth and traditional IRA
The maximum amount you can contribute to an IRA, both Roth and traditional, is $6,500 per year ($7,500 if you're 50 or older). While you can technically contribute to both, choosing one for a given year generally makes sense. Which you choose often comes down to your current versus projected tax bracket in retirement.
A Roth IRA could be more beneficial if your current tax bracket is lower than you expect your tax bracket to be in retirement. This allows you to pay taxes on your contributions at a lower rate now and then enjoy tax-free withdrawals in retirement when your tax rate may be higher.
On the other hand, a traditional IRA could be a better choice if your current tax bracket is likely higher than it'll be in retirement. You get a tax deduction on your contributions now (reducing your current tax bill) and then pay taxes on your withdrawals in retirement when your tax rate might be lower.
Those aren't the end-all rules for choosing between the two account types, but it should be a major consideration. Another thing to consider is whether you're on pace to cross the income limit for Roth IRA eligibility. For tax year 2023, the most you can earn and still be eligible to contribute to a Roth IRA is $153,000 if you're single and $228,000 if you're married and filing jointly.
If you believe you'll eventually cross that threshold, it's best to take advantage of a Roth IRA while you can. Your investments will continue to grow long after you're ineligible. It's one of the best tax breaks you can receive.
