Most retirement accounts offer tax benefits. Some have tax benefits today, others offer tax benefits tomorrow. Some have high limits, some have low limits.
The biggest difference is whether your contributions are tax deductible, and as a result, whether taxes are deferred or if growth is tax free.
For most people, there are three main types of retirement investing options:
- 401(k): With this type of plan, offered by many private sector employers, you can contribute a fair amount toward your retirement — $17,500 in 2014. With a Traditional version of the 401(k), your money is contributed before taxes, meaning that you receive a tax deduction that lowers your income, or in other words, you have a lower tax liability now. However, in the future, when you withdraw your money from your account, you have to pay income taxes on the amount you withdraw.
- 403(b): This plan is very similar to the 401(k), and with the same limits. However, the 403(b) is generally offered to state employees and non-profit employees. Most of the same rules apply to the 403(b) as to the 401(k).
- IRA: An Individual Retirement Account is usually just that – individual. Instead of being offered by employers (even though some employers do offer IRAs), you can open this type of account if you have earned income. You can open it on your own, without the need for an employer to provide you with the plan. However, the contribution limit is lower with the IRA, at $5,500 in 2014. If you decide to consolidate your retirement accounts (for example, if you have a 401(k) from a former employer), you can roll all of your funds into one IRA. A direct rollover does not count toward your annual maximum contribution.
It’s possible to have different types of retirement accounts. If your employer offers you a 401(k) or a 403(b), you can still open an IRA. You can contribute $17,500 to your 401(k) in 2014, and still contribute $5,500 to your IRA (in a Traditional or if your income is low enough for a Roth), for a total limit of $23,000 in contributions in 2014.
However, be aware of exceptions. Your income will determine what kind of IRA (Roth or Traditional) and if you can deduct the contributions. For more information on the exceptions, read Can You Have a 401(k) and an IRA?
Roth v. Traditional Retirement Accounts
All of these accounts also come in versions known as Roth accounts. With the Roth version of the 401(k), 403(b), and the IRA, you contribute your money after you pay taxes. Roth contributions won’t reduce your taxable income right now.
With the Traditional versions, there are two potential tax benefits. The first is deductibility, which can reduce your current income taxes if it applies to you. The second is tax-deferral, which can amp-up your gains due to the magic of compound interest.
The Roth retirement account is a little different because you don’t get a tax deduction for your contributions but you also don’t pay taxes when you take disbursements. Your money grows tax-free all the same, you just pay taxes up front. This can be an advantage if you think that taxes will go up in the future.
The Best Approach
Readers of my blog often ask whether it’s better to contribute to a Traditional or Roth version of a particular account.
I believe it’s impossible to project where taxes will be in the future. While it’s important to consider tax benefits, it’s more important to save. I suggest that you contribute as much as you need to maximize the company match, then into a Roth IRA*, then back into your 401(k) or 403(b). This will typically give you a good enough mix of Roth and Traditional that you hedge your bets regardless of what happens with tax laws in the future.
*Roth only if your income allows