401k or IRA: Which One Should You Invest in First?

March 9, 2016

9-minute read

Confused about whether to invest in a traditional or a Roth retirement account? Laura answers a listener question that will help you understand the rules and prioritize contributions among different types of retirement accounts.

441 MG 401k or IRA: Which One Should You Invest in First?

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Investing through one or more retirement accounts is a smart way to save for your future and cut taxes at the same time. But these special accounts can also be confusing because they come loaded with rules and limitations.

I received a great question from a Money Girl Podcast listener named Sharif Y. He says, “I just graduated college and started my first real job with good pay and a 401k that matches up to 3% of my contributions. So I plan on contributing at least that much to get the free money from my employer. If I can invest more, should it go to the 401k or in a Roth IRA instead?”

In this post, I’ll answer Sharif’s question and help you prioritize contributions among different types of retirement accounts depending on your objectives. Leveraging a variety of options allows you to invest as much as possible and to create more financial security.

Free Resource: Laura’s Recommended Tools—use them to earn more, save more, and accomplish more with your money!

Different Types of Retirement Accounts

Not only are there a variety of retirement accounts for individuals, employees, and the self-employed, but most offer a traditional and a Roth option. Additionally, Roth rules for workplace plans are slightly different than Roth rules for IRAs.

See why I said it’s confusing? Don’t worry, I’ll make it really clear so you know exactly what to do by the end of this post.

For a quick review, IRA is short for Individual Retirement Arrangement. You own it as an individual and choose your own investments. For 2016, you can contribute up to $5,500 (or $6,500 if you’re over age 50) to a traditional IRA, a Roth IRA, or to a combination of them. In other words, you could contribute $2,000 to a traditional IRA and $3,500 to a Roth—but not $5,500 to each one.

Retirement plans through work—such as a 401k, 403b, 457, or Thrift Savings Plan (TSP) for government employees—are completely different from IRAs. They’re managed by employers only, offer a set menu of investment options, and require contributions to be deducted out of your paycheck.

Many workplace plans also offer a Roth option. You can even split up contributions between traditional and Roth plans, as long as you don’t exceed the annual limit. For 2016, you can contribute up to $18,000 (or $24,000 if you’re over age 50) to most workplace retirement plans.

Additionally, if you’re self-employed, there are a variety of accounts you can use, such as a solo 401k, SEP IRA, and SIMPLE IRA. However, most of them don’t offer a Roth option.

What Are the Differences Between a Traditional and Roth Retirement Account?

Traditional versus Roth is kind of like choosing a Mac or a PC. They’re both computers but have completely different operating systems with their own pros and cons.

So how do you choose the right retirement account(s)? What’s best for you depends on various factors, such as:

your income
what’s offered by your employer
whether you have self-employment income
how you plan to use the money
whether you want an upfront tax deduction
what your future tax rate could be

Let’s start by discussing the main differences between traditional and Roth accounts, so you understand who can have them and what they accomplish.

Traditional versus Roth is kind of like choosing a Mac or a PC. They’re both computers but have completely different operating systems with their own pros and cons.

Here’s an overview of their tax differences:

A traditional retirement account, such as an IRA or workplace 401k, allows your investment to grow tax-deferred. That means you don’t pay tax on your contributions or earnings until they’re withdrawn. You generally can’t withdraw money until you reach age 59½ without paying income tax plus a 10% early withdrawal penalty. But you must begin taking withdrawals after you turn 70½–unless you have a workplace retirement plan and are still working.
A Roth retirement account, such as a Roth IRA or Roth 401k, allows your investment to grow tax-free. You pay tax upfront on your contributions, but owe no additional tax on contributions or earnings when you take withdrawals, as long as you’ve had the account for 5 years.

With a Roth, you’re never required to make withdrawals, so you can contribute after age 70½ and your account can grow tax-free for your entire life.

The only limitation is that if you exceed an annual income threshold you become ineligible to make contributions to a Roth IRA. I’ll explain more in a moment.

If you want more information about how using a traditional or Roth retirement account would affect your taxes, check out H&R Block’s Tax Calculator or make an appointment with a tax professional.

Should You Have a Traditional or a Roth Retirement Account?

In addition to taxes, there are other considerations. To know whether you’re better off owning investments in a traditional or Roth retirement account, start by answering these 3 questions:

Question #1: What’s my current income?

This is the first question to answer because there are annual income limits to qualify for a Roth IRA. However, this isn’t the case for a Roth account at work, or any type of traditional retirement account.

If your income is above the annual allowable limit, you’ll be locked out of opening up or contributing to a Roth IRA.

So, if your income is above the annual allowable limit, you’ll be locked out of opening up or contributing to a Roth IRA. Here are the 2016 thresholds by tax filing status for your modified adjusted gross income:

Married filing jointly: $194,000
Single or married filing separately if you don’t live together: $132,000
Married filing separately if you do live together: $10,000

Sharif mentioned that he’s well paid and I’m assuming that he’s single. So if he makes more than $132,000, he can’t contribute to a Roth IRA.

Let’s say you already own a Roth IRA, and your income goes up and exceeds the annual allowable limit. If that happens it’s not a problem; you can continue to own and manage the account with no penalty, you just can’t add new funds to it.

On the other hand, as I mentioned, there is no income limit to qualify for a Roth account at work. So, you can have one no matter if you’re in an entry-level job or happen to be the highest paid employee in the company.

Sharif didn’t mention if his 401k includes a Roth, so I’d recommend that he check into that option. Since you can contribute over three times as much to a 401k than an IRA, it gives you the opportunity to save a lot more.

See also: 10 IRA Facts Everyone Should Know

Question #2: Is my tax rate likely to be higher or lower in retirement?

As I previously mentioned, with any kind of traditional retirement account you get a break by delaying taxes until you take withdrawals in retirement. Roth accounts work the exact opposite way. With a Roth, you pay tax upfront, and then have no tax on withdrawals in retirement.

In order to pay as little tax as possible, consider whether your income tax rate could be lower now relative to when you retire. If you believe that you’ll be in the same or a higher tax bracket in retirement, choosing a Roth IRA or a Roth at work, if available is best.

The idea is that paying tax on Roth contributions upfront at a lower rate saves you money. Here are some situations where your tax rate could be higher in retirement than it is today:

You’re currently in an entry-level job and expect to be earning more in the future.
You expect to receive an inheritance in the future.
You have a hunch that income tax rates for all Americans will escalate over time.

But if you’re further along in your career and earn more now than you believe you will in retirement, you’re generally better off with a traditional IRA or traditional plan at work. When you take withdrawals in retirement, you’ll end up paying less tax if you have a lower tax rate than you do today.

Also, if you have a heavy tax burden from high earned or investment income, making contributions to a traditional retirement account is a smart way to cut it. You’ll get a tax deduction in the year you make traditional retirement contributions, which reduces your current tax bill.

Problem is, none of us really know what will happen in the future, especially if you’ve got a long way to go until retirement. So, if you’re not sure about your tax rates, another tip is to diversify by having both traditional and Roth accounts. That way you’ll have taxable and non-taxable money to spend in retirement.

For instance, you could put half your contributions in a traditional 401k and half in a Roth 401k. Or you might have a traditional retirement plan at work and a Roth IRA on your own, if you’re eligible.

Free Resource: Retirement Account Comparison Chart (PDF download)

Question #3: Do I want flexibility to tap the account before retirement?

Tapping a retirement account before you reach the official retirement age of 59½ typically comes with having to pay tax, plus a 10% early withdrawal penalty. While you might think it’s unfair to have your wrist slapped, financially speaking, to access to your own money, the purpose is to make sure you have funds to spend in retirement, not before!

However, there are some exceptions. Roth accounts give you much more flexibility than traditional ones when it comes to taking early withdrawals. And a Roth IRA, in particular, gives you the most access to your money.

Since you make contributions to a Roth on an after-tax basis, you can withdraw them for any reason without owing taxes or a penalty, no matter your age.

Since you make contributions to a Roth on an after-tax basis, you can withdraw them for any reason without owing taxes or a penalty, no matter your age. However, if you tap the growth or earnings on your original contributions, taxes and a 10% early withdrawal penalty will apply.

In addition to the 3 questions I covered, there are other features of traditional and Roth retirement accounts that may be important for your situation.

Let’s say you earn too much to qualify for a Roth IRA and decide to open up a traditional IRA. If you or a spouse also have a retirement account at work, the amount you can deduct for contributions to your traditional IRA may be reduced.

For a summary of all this information, plus more pros and cons of different retirement accounts, click here to download the Retirement Account Comparison Chart.

Should You Invest in a 401k or Roth IRA First?

If you’re like Sharif and want a Roth, find out if you have access to one through your workplace retirement plan. Not only do you avoid the income threshold that comes with a Roth IRA, but you can contribute over three times as much. So that’s where I’d invest first.

But if you don’t have a Roth at work or are self-employed, it’s easy to open up a Roth IRA—as long as you earn more than the income limits that I mentioned.

Here are some of the best places to open a retirement account for individuals or the self-employed.

Remember that a 401k, IRA, or any kind of retirement account itself is not an investment—it’s just a special type of account. It’s like an umbrella that shelters what’s underneath from taxes.

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About the Author

Laura Adams, MBA

Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.

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