Are you looking for some retirement accounts where you don’t need to pay taxes on what you’re earning or where you’re investing?
Everyone dreams of living a safe and secure life after retirement. That’s why it’s always good to start saving and investing the money before your retirement. And for this, you need to understand different retirement accounts. So, let’s dive deep into this guide and learn about Traditional and Roth IRAs. And a comparison between both of them along with contribution limits and tax implications. This will help you choose the right one.
Let’s start with it!
Table of Contents
401(k) Plan
A 401(k) retirement accounts savings plan is offered for employers along with tax saving benefits. It is named after the U.S. Internal Revenue Code (IRC).
The employee with a 401(k) savings plan agrees to have a percentage of each paycheck paid into an investment account. The employee is provided with an option to choose among several investment plans, preferably mutual funds
There are some other plans associated with 401(k) plans, and those are:
403(b) Plans
A 403(b) plan is similar to a 401(k) plan, but it is provided by charities, public schools, and some churches.
Employees contribute pre-tax dollars to this retirement plan. These contributions reduce their taxable income and allow the funds to grow tax-free until the employee retires, when withdrawals are also typically tax-free.
During retirement, if you made any withdrawals then it will come under the ordinary income, and distributions before age 59 and a half might charge penalties and additional taxes.
457(b) Plans
A 457(b) plan looks similar to a 401(k), but it is meant for the benefit of employees of local & state governments and some tax-free organizations.
In this tax-benefit retirement savings plan, an employee can contribute with pre-tax wages, which means it is a tax-free income. It also allows the contributions to grow tax-free until the time of retirement, and at the time of money withdrawal, it eventually becomes taxable.
How Does a 401(k) Plan Work?
The government created the 401(k) retirement accounts to encourage Americans to save for retirement by offering tax benefits.
There are two primary options with distinct tax-saving advantages.
- Traditional 401(k)
- Roth 401(k)
Traditional 401(k)
A traditional 401(k) allows the American government to deduct the amount from an employee’s gross income. It means the money comes from the paycheck before the deduction of taxes.
Contributing to a 401(k) retirement accounts plan lowers your taxable income for that year. The total amount of your annual contributions acts as a tax deduction. In addition, there will be no tax dues on either the investment earnings or the collected money until you withdraw the money at the time of your retirement.
Roth 401(k)
A Roth 401(k) allows the American government to deduct the amount from your after-tax income which means contributions come from your paycheck after the deduction of income taxes.
Consequently, there’s no tax deduction in the contribution year. When you withdraw the amount at the time of retirement, you do not have to pay any add-on taxes on your contributions or investments.
Difference Between a Traditional 401(k) and a Roth 401(k)
A traditional 401(k) retirement accounts plan allows pre-tax contributions, whereas the Roth 401(k) includes after-tax contributions.
When you only take required minimum distributions from a Roth 401(k), it is tax-free money. Since contributions to traditional 401(k)s go in before taxes, you pay taxes on them when you withdraw the money at your current tax rate.
Contribution to a 401(k) Plan
Traditional & Roth 401(k) plans are the defined contribution plans. Both the employer and the employee can contribute to the account in dollar limits set by the IRS (Internal Revenue Service).
Employees’ contributions to a traditional 401(k) retirement account plan will adjust their gross income and reduce their taxable income. Contributions to a Roth 401(k) include after-tax dollars and don’t have an impact on taxable income further.
Contribution Limits of Traditional and Roth 401(k)
The contribution limit for retirement savings plans is increasing to $23,000 in 2024, up from $22,500 for individuals under 50.
In 2023, you can stash up to $22,500 in a Roth 401(k) – $ 30,000 if your age is 50 years or above.
The total contribution limit of both employee and employer contributions is $66,000 (or $73,000 for over-50s)
What is an IRA?
People with earned income can leverage Individual Retirement Accounts (IRAs) as tax-advantaged, long-term savings accounts to accumulate funds for their future.
Self-employed individuals can establish IRAs as an alternative to employer-sponsored retirement plans, like 401(k)s, which they may not have access to. However, anyone with a retirement plan can open an IRA and similarly invest in it.
IRA can also be open via an investment company, bank, personal broker, or an online brokerage.
How Does an IRA Work?
Individuals with earned income can easily contribute and open an IRA savings account, with those who have a 401(k) account through an employer. The only drawback it carries is the total contribution to your retirement accounts in a year.
When you open an IRA savings account, you are free to invest in a huge range of financial products that include mutual funds, bonds, stocks, and exchange-traded funds (ETFs).
There are self-directed IRAs (SDIRAs) that allow investors to make all the investment-related decisions. SDIRAs provide access to a wide selection of investments, such as commodities and real estate.
Types of IRAs
There are manifold IRAs with distinct rules about taxation, eligibility, and withdrawals, which include:
- Roth IRAs
- Traditional IRAs
- Savings Incentive Match Plan for Employees (SIMPLE) IRAs
- Simplified Employee Pension (SEP) IRAs
Individual taxpayers can establish Roth and traditional IRAs while self-employed individuals and small business owners can set up SIMPLE and SEP IRAs.
1. Traditional IRAs
Traditional IRAs are tax-benefit savings plans that are usually managed by the people only. Anyone with taxable income can make contributions to a traditional IRA, so an IRA may be attractive if you do not have access to an employer’s 401(k) plan.
Traditional IRAs are somehow similar to 401(k), including the way the tax advantages work. Your contributions lower your taxable income, the money will increase tax-free until you withdraw the amount, and there are similar limitations of age concerning contributions and withdrawals.
However, there are also huge disparities between traditional 401(k) and IRAs. You can select between many IRAs from distinct financial service organizations, and each plan might include a wide range of investment options, such as mutual funds and stocks.
In some cases, you might be able to contribute to a 401(k) and an IRA account in the same year. Be aware that your IRA contributions might not be tax-deductible if you or your spouse participate in another retirement plan at work AND your household income exceeds a specific threshold set by the IRS.
2. Roth IRA
The difference between traditional and Roth IRAs is when you get the tax benefits. You need not pay income tax on your contributions in a traditional IRA, but it is different when you take the money out.
The case is the opposite when it comes to a Roth IRA, you need to pay taxes on the money you contribute, but you can withdraw money tax-free during retirement; with this, every dollar is coming into your pocket.
There are other disparities between a traditional IRA and a Roth IRA.
Unlike traditional IRAs which mandate withdrawals starting at age 72, Roth IRAs offer more flexibility. You are not required to take mandatory withdrawals at any age, and you can even access your contributions without penalty before retirement, though some restrictions may still apply. In addition, you can only contribute to a Roth IRA if the income is too low, or below a particular threshold, similar to a traditional IRA.
3. SEP IRA
Self-employed people like freelancers, small business owners, and independent contractors can set up SEP IRAs.
A SEP IRA follows and sticks to the same tax rules for withdrawals as a traditional IRA. SEP IRA contributions are limited to 25% of compensation or $66,000, for 2023.
For 2024, the maximum allowed contribution is $69,000.
4. SIMPLE IRA
The SIMPLE IRA is designed for self-employed individuals and small businesses. This type of IRA follows the same taxation rules for withdrawals of amounts as a traditional IRA.
The contribution limit for SIMPLE IRA is $15,500 in 2023 and the catch-up limit (for workers age 50 and older) is $3,500.
For 2024, the contribution limit is $16,000 and the maximum catch-up limit is $3,500.
IRA Contribution Limits
The Internal Revenue Service (IRS) sets and enforces contribution limits for retirement accounts like IRAs. This ensures responsible saving habits and avoids overly large contributions.
The highest contribution limits for the year 2024 for traditional and Roth IRAs are:
- $7,000 if you’re younger than 50 years of age
- $8,000 if your age is 50 years old
The highest contribution limits for the year 2023 for traditional and Roth IRAs are:
- $6,500 if you’re younger than 50 years of age
- $7,500 if your age is 50 years old
Traditional vs Roth IRA
The key difference between traditional and Roth IRAs lies in when you pay taxes on your contributions and earnings.
Traditional IRA contributions allow you to contribute pre-tax dollars, reducing your taxable income for the year you make the contribution. Essentially, you’re setting aside money for retirement before taxes are applied. In this, you pay taxes on earnings and contributions when you withdraw the amount.
On the contrary, contributions to Roth IRAs are made with post-tax dollars. It is the money on which you have paid taxes. There is no immediate tax break (in comparison to a traditional IRA) but in case you retire and start to withdraw the amount, the money that you earned and paid in is tax-free.
How are 401(k) Retirement Accounts Plans and IRAs different?
Both (401(k) and IRA) retirement accounts plans have contribution limits, but 401(k) serves a higher annual limit as compared to IRAs.
On the contrary, IRAs mostly provide more liberty to people to choose between different investment plans, while the investment plans available with 401(k) plans are more restricted.
Both types of retirement accounts are an excellent way to save the penny, but you don’t have to choose between the two as it is feasible to invest in both 401(k) and IRA plans simultaneously.
Also, explore this blog: Understanding Different Savings Account Options
Key Takeaways
Everyone should consider going for retirement accounts, especially if you want to live the lifestyle that you currently have. The several types of retirement plans differ in various aspects like contribution limits, withdrawal rules, and when you pay income tax.
Some retirement accounts designed for business owners, sole proprietors, and employees. However individuals may not be eligible for these retirement savings plans for numerous reasons, so it’s important to take advice from financial consultants and change the game by putting your best foot forward.
