401k, Traditional IRA and Roth IRA Savings Not The Same

by David Ning · 27 comments

401k vs roth ira
Almost every week, I read an article telling me how big of a nest egg I need to retire comfortably, and almost every time, I think about my own retirement funds and try to compare it to the guidelines. Yet, every single time, I ask myself:

Is the retirement savings being referred to a post or pretax amount?

It seems like minor detail, which makes the point all the more important. Pretax retirement savings does not equal post tax funds. Make sure you take this into account when you do your retirement planning, or risk a true awakening when you can least afford it.

ira vs roth vs 401kWhat I’m saying sounds obvious now, but many people seem to forget that taxes will eat up a good portion of the 401k. Just because you have $30,000 in the plan doesn’t equate to the same amount in your online savings account.

How You Should Look at Your Retirement

When I do a quick tally of my retirement savings, I discount 40% of any account that will still be taxed. For example, any retirement accounts like the SEP IRA, Traditional IRA, and 401k is worth less than the number you see on your statement. Others, like the Roth IRA or your taxable investment account, is worth the full amount. This sounds trivial, but let’s use a hypothetical example to drive home this important point. Let’s say that Joe has the following saved up:

  1. Traditional IRA (rolled over from previous work)- $60,000
  2. 401k – $22,000
  3. Roth IRA – $8,000
  4. Savings – $8,000

Total = $98,000

Having close to $100,000 for retirement already saved up is a substantial amount, but is it really that much? If we discount the taxes that he will incur come retirement, the numbers become (I just take a simple 30% off as a quick, dirty and conservative way of doing this):

  1. Traditional IRA – $48,000
  2. 401k – $17,600
  3. Roth IRA – $8,000
  4. Savings – $8,000

Total = $81,600

$81,600 is not too shabby, but it’s not quite $100,000.

Okay, You Have My Attention, Now What

Even though the point I’m making is fairly obvious, many of us don’t think about the true value of our nest egg when we just glance at our 401k and IRA statements every quarter. If you are actively planning for your retirement, I strongly suggest doing a similar calculation and see if you are still on track. If anything, you will be more conservative and have more money to spend in retirement – hardly a bad situation.

Here Are Two More Retirement Savings Options You Might Not Have Considered

And now that you are thinking about the difference of pre-tax and post-tax retirement savings, let’s take a look at another two options you hear about less often. Most people are familiar with the standard retirement savings accounts — 401(k)s, Traditional IRAs and Roth IRAs. Each has its advantages and disadvantages when it comes to contribution limits, tax breaks, and the ability to maximize your portfolio. And many of these depend on where you’re at in your life, career, and finances. For instance, many financial advisors say Roth IRAs are a better bet for younger workers, and that IRAs, in general, are a better choice than an employer-sponsored 401(k) since they allow you to choose your provider and give you more investment options.

But there are a few other retirement savings account options you might not be aware of that could be better for you, financially. Two of them include the Simplified Employee Pension (SEP)-IRA and the Health Savings Account (HSA). Let’s look at how these retirement savings options work and who might (or might not) be the best candidate for them.

Simplified Employee Pension (SEP)-IRA

This one was new to me, so I’m guessing it could be new to you, too. This is probably because it doesn’t apply to you, but I’ll let you make that judgment.

The SEP-IRA is designed for solopreneurs or entrepreneurs with only a few employees. This retirement savings account has a higher annual contribution limit ($55,000 per year in 2018, and no more than 25% of your self-employment income) than traditional IRAs. That’s good news for business owners who want to maximize their retirement income.

This type of account is also unique in that the contributions you make won’t count against your IRA contribution limit because you’re making them as an employer, not an employee. In other words, you could have both types of accounts and still get the most bang for your retirement buck. And, finally, you’ll have more options and freedom of choice than you would with a 401(k).

Of course, there are downsides. The biggest one is for those who have employees. If you contribute a certain percentage of your income to a SEP-IRA and you have employees, you’re required to contribute the same amount to SEP-IRAs for each of them.

Basically, if you’re a solopreneur who is officially self-employed or has a significant side-gig, a SEP-IRA is worth looking into.

Health Savings Account (HSA)

Are you already questioning how an account that’s paired with a high-deductible insurance plan and is designed to offset out-of-pocket medical expenses could also be a valid retirement savings option? I was. The secret is that, during your working years, you can only use HSA contributions for qualifying medical expenses. But, after age 65, you can use the money for anything. Neat, huh?

Unlike its cousin, the flexible spending account (FSA), you don’t “use it or lose it,” so you can continue to grow the amount until retirement age. You also aren’t obligated to start withdrawing funds at age 65 if you don’t need it yet.

The coolest thing about HSAs is their tax break potential. Contributions to HSAs are pre-tax or tax-deductible, distributions are tax-free, and any dividends, interest, or gains you make are also untaxed. Some financial experts say this is one of the most tax-advantaged ways to save for retirement.

To open an HSA, you need to have a high-deductible health insurance plan with no other insurance on the side. You also can’t be eligible for Medicare or be claimed as a dependent on someone’s tax return. On the downside, high-deductible health plans can make it hard to pay for your medical expenses. If you have a lot of medical bills during your working years, the payoffs of an HSA after retirement might not be worth it to you.

Which Retirement Savings Option is Best for You?

These two options are just that – more potential ways to maximize your retirement savings now, and your income later down the road. Choosing a retirement savings vehicle is a very personal decision that draws on your age, where you’re at in your career, and your personal risk tolerance. It’s important to explore all your options, seek advice from trusted professionals, and ultimately, to remember that saving for retirement — in any fashion — is better than not saving at all.

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{ read the comments below or add one }

  • Julia says:

    I don’t see a comment about 401(k) plans and the company match you may receive if you contribute to that. Even better would be a nonelective contribution like a profit sharing contribution, but you should at least be putting in money to get the full company match before shifting over to an IRA.

  • Lee says:

    Hi, If i contrubute $16500 to my company 401K can i also contribute $5000 to a tax defered traditional IRA for my spouse if she has not income,

    • MoneyNing says:

      You should be able to contribute $5k to a traditional IRA for your spouse if you are married, file a joint tax return. However, I would highly recommend talking to a certified CPA about your situation because depending on your circumstances, you may find that other arrangements are even more beneficial.

  • Great article and great post. Yeah the tax system can seem a little unfair with higher income people getting taxed more then lower income people. But it’s really the only way that the system will work it would fall apart if we were all taxed the same the lower income people wouldn’t be able to afford the tax.

  • Hashim says:

    Josh, you can contribute the maximum $16500 to a 401k and also contribute to a Roth IRA ($5000) if your employer allows it. Here’s some additional info:

    Coverage under a retirement plan maintained by your employer does not affect your ability to contribute to a Roth IRA. If you meet the requirements described below, you can contribute to a Roth IRA even if you participate in an employer plan such as a 401k. Even if you contribute to a Roth 401k account, your contributions to a Roth IRA are unaffected.

    But you have to meet certain requirements, they are your adjusted gross income cannot exceed certain limits and your income must be qualifying compensation

    Compensation or Alimony Income
    For each year you contribute to a Roth IRA, you (or your spouse, if you file jointly) must have compensation or alimony income. If you don’t have compensation or alimony income you can’t contribute, even if you have other types of income. And if your compensation or alimony income is less than the maximum contribution, the amount you can contribute is reduced.
    Source: http://www.definerothira.com

    Compensation income. Compensation income includes amounts you receive from your employer of course, but also includes self-employment income from your own business or from a partnership that generates this type of income. There’s a special rule that treats alimony income as compensation income, just for purposes of determining how much you can contribute to an IRA. That means you can contribute to an IRA if you receive taxable alimony payments, even if you don’t work for a living. Compensation income does not include investment income, pension income or non-taxable income.
    Spousal Roth IRA. If you file jointly with a spouse who has compensation income, you don’t need compensation income of your own. You can contribute to a Roth IRA based on your spouse’s compensation income.

  • Josh says:

    i have question or two:

    1. between me and my wife, can we put 10,000 (for 2009 yr – I know the deadline was today but I am just asking) in ROTH IRA? Could we open a joint IRA account at lets say Fidelity and have 10,000 deposited or do we have to have separate accounts since one person limit is only 5,000?
    2. I have 401K at work and wife does not (she has pension but she won’t qualify for another yr). I know I can put 16500 max (again assuming 2009 limits) in my 401K but I am confused between 401K, traditional and Roth. If I did put 16500 in my employer 401K, can I also put 5000 in traditional IRA and 5000 in Roth IRA? That is total 26500 per person allowed to be deposited in retirement account, correct? I do know that only 21500 is pre tax and 5000 in Roth is after tax.
    3. since my wife doesn’t have 401K at work, can she only do traditoinal and Roth totaling 10000? Is there any other way to save more? (I know she has option to get paid on 1099 basis vs W2 fm work – would that be beneficial over getting paid in W2?

    Thanks a bunch guys.

    • MoneyNing says:

      1. Unfortunately, all IRAs need to be separately owned, so you will need one account while she needs the other. I wish they could change this too, but it is the way it is to protect us since it’s OUR OWN retirement.

      2. You can contribute to a 401k or a traditional IRA, but not both at the same time. You can however contribute to a 401k, and a ROTH IRA on top of that. So it’s $16,500 tax deferred and $5,000 after tax dollars.

      3. The total of your IRAs can only be $5,000 for 2010 if you are under 50 years old. So even though your wife doesn’t have a 401k, she can’t go over the contribution limit.

      Hope this helps.

      • Josh says:

        thanks for the answers. One additional question on item 3: did you mean that she can only put 5000 ROTH or 5000 Traditional IRA but not both? she doesn’t have 401K at work so she can only put 5000 total between both IRAs? please confirm. thx.

  • What a nice, clear recitation of the considerations we must keep in mind as we slog along towards retirement. Hopefully when the time comes something will indeed be left.

  • RB @ RichBy30RetireBy40 says:

    The problem with IRAs is that it unfairly penalizes those who make more money. I forget what the exact cut off is, but if you make more than $85,000 as a single individual, and definitely more than $100,000, you can’t contribute.

    The average income of an MBA student out of a top 25 school is about $100,000 and 28 years old. Why is the system punishing 28 year olds who pursued further education? The limit needs to be raised by 3X at least.

    My first job out of college, and I was already cut off the IRA system. Fast forward 10 years later, I’ve lost a lot of potential retirement funding. I’ve only been able to contribute on average 15K a yr for 10 years out of school in the 401k. I think the 401K limit of 16.5K this year should be raised to at least 25K. People who work for 30 years saving 16.5K are not going to be able to retire comfortably.

    Best,

    RB
    RB30RB40

    • MoneyNing says:

      It’s true that our tax system is setup where the high earners are taxed much more than the lower income earners.

      While I don’t like it one bit, it’s important to note that without doing it this way, the tax system would cripple every lower income earner because tax rates across the board would be higher. Of course, what we really should be doing is stop all the money the government wastes and tax everyone fairly to promote productivity but that’s much easier said than done.

      RB, be thankful that you were privileged enough to attend graduate studies and came out the gate having a job that others can only dream about. Despite the fact that you probably worked really hard to obtain your degree, there are many others who never even got the chance to try.

  • Wilson Pon says:

    Ning, you know what? You’ve cleared all my doubts here. I always being asked by my friends the differences of Traditional IRA and Roth IRA. In this case, I think they should come over and read your article thoroughly.

  • Emma says:

    I love my Roth IRA account because of the exactly same reason as what Craig said. Without the worry of taxes, I know what I saved in my Roth is rock solid and dependable.

    On the other hand, who knows what will happen to the 401k tax structure as we get more and more into debt?

  • Craig says:

    That’s why I recently started my Roth IRA and like it. It gets taxed now which can hurt a bit cause when I add money it really doesn’t seem like anything is increasing, but I know whatever is in there is fully mine when I retire. Mentally makes it easier for me.

  • marci says:

    I’ll be retiring in 4-7 years, so the amount of money I have tucked away will not be affected too much in that span of time by inflation, but it will be a factor in the 40-some years following that. If I keep my income stream low, (under $20,000/yr) I should not be affected much by tax increases either.

    Yes, I’ll still be able to stay under the 8.5 federal even with health care, provided there are no really big things…. and if there are really big things, well then, that’s another story – I probably won’t have done whatever it is that “they” want done as I don’t believe in putting fake manmade organs in my body…personal choice there. If I die tomorrow, I have no regrets 🙂 But I have my money planned out til I’m 103, so you see I am planning far far ahead 🙂

    The thing is about withdrawing money… I’ll have SS $800/mo and a pension of $400 month. That’s more money than I take home now per month, and I save part of what I take home now. I should not have to touch the IRA’s nor investment income – they’ll just be there for emergencies 🙂

    The deal is, if you don’t spend money, you don’t need to withdraw money. Simple as that 🙂 Being debt free and doing for yourself makes life much simpler and makes the need for more income almost non-existant 🙂 Simplify and do for yourself.

    • Jodi says:

      I think inflation is actually going to be much worst than 3% due to the massive borrowing that we are doing currently. However, even at 3% a year, everything will be 23% more expensive in 7 years. Then it will be another 3% more every year after retirement. No one is immune unfortunately.

  • marci says:

    I agree – you’re rate of 40% seems very excessive. I won’t be earning any more at 62 than I am now – and my nice little 8.5% tax rate, doubled for state, leads me to believe that if I use 20% for retirement tax rate – tops- that I will be covering all the bases, and have a lot left over.

    I live on very little now (by choice) and intend to do the same later on 🙂

    • MoneyNing says:

      It’s always great to hear about your discipline in spending 🙂 What do you think about my other comment on inflation? How will that affect your retirement?

      What about health care expenses once you stop working? Are you still going to be able to withdraw so little your tax rate is just 8.5% federally?

  • There is no tax unless you take more than your standard deduction+personal exemption. Last year that amount was about $18,000 per year (Married Joint).

    Assuming you have no income when you’re 65, taking out $20,000 per year, your tax rate will be $0. Roth IRA has no tax even if you’re making $5,000,000+ per year.

    Unless you’re be making $$,$$$ per year when you’re 65 and taking out 401K then you’re going to get taxed. 40% is extremely high for “average people”. Unless you’re working for Goldman Sachs, most people probably won’t be taxed at this rate.

    • MoneyNing says:

      40% might be too high but it’s not going to be much lower. $20,000 per couple by the time you are retiring is going to be a stretch because of inflation. Let’s say that you are currently 40 and have 25 years till retirement. At 3% inflation, $20,000 is probably worth more like $10,000 in today’s dollars so it’s hardly enough to live on. By the time you are 90, $10,000 will be more like $5,000.

      This is very rough calculation but let’s say $150,000 gets you a 35% tax rate (+/- the progressive tax system, and add state tax). 25 years from now, $75,000 of purchasing power will be taxed at 35%. 50 years from now, it’s $37,500 only. All this is also assuming that the tax rate isn’t going up, which everyone thinks is likely.

      Also, income taxes will tax all sorts of income, including interests from CDs and savings, which you will probably have in addition to your retirement accounts.

      • For what it’s worth, tax brackets, the standard deduction, and personal exemptions are usually adjusted annually with the intention of keeping pace with inflation.

        That said, I am in the group of people who expects higher tax rates in the future. It seems like an inevitability given our enormous deficits, combined with an increased worldwide reluctance to lend money.

  • You raise a great point. Randomly enough, I have a very related post going up tomorrow–essentially reminding people that they need to take note of pre-tax or post-tax when calculating their asset allocation.

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