A common myth about retirement planning is that 401k accounts are always superior to IRAs. On its face, this myth appears true. You can contribute significantly more to a 401k each year than an IRA.
You can contribute $18,500 to your 401k, versus $5,500 to your IRA for workers under 50 years old. That contribution limit rises to $24,500 for your 401k versus $6,500 for your IRA for workers ages 50 and above. 401k contributions lower your tax burden year-after-year. Some employers even offer matching contributions of up to 3-6% for 401k accounts.
However, the math behind the 401k versus IRA debate is much more complicated, as recent tax reform efforts might suggest. Investing in both your 401k and a separate IRA might actually be the best strategy.
Tax Deductions for 401k Retirement Accounts
To simplify this complex issue, here are a few considerations to make while evaluating your retirement savings strategy.
The biggest advantage 401k accounts offer is the pre-tax nature of your contributions. So, if you make $100,000 in a year and contribute $18,000 to your 401k, then you’ll only be taxed on $82,000 of your income. This means you can’t deduct 401k contributions on your taxes, since they’re already excluded from your income before your W-2 arrives. However, contributions to a traditional IRA are tax-deductible.
Roth IRAs are not tax-deductible in the present year, but you’ll be able to access that money tax-free when you withdraw after age 59½. People who assume 401k accounts are always preferable to Roth IRAs often argue that your income tax rate is likely higher in your pre-retirement working years. This makes the 401k pre-tax contributions more favorable when it comes to tax savings.
However, you can’t predict what your income will be in the future, or what the income tax rates might be 10-40 years down the line, and some people use their 401k plans as emergency funds. So, a 401k isn’t a clear winner simply because your contributions occur on a pre-tax basis.
What Counts as Income in Retirement?
Since contributions to Roth IRAs are taxed in the same year you funded the account, withdrawals from your IRA during retirement do not count as income for tax-related purposes. 401k distributions and traditional IRA withdrawals do count as income during retirement however. This can increase your income tax burden. Your income during retirement also affects how much you pay for Medicare Part B premiums.
Other sources of retirement income subject to taxation include retirement pensions, investment income from non-retirement accounts, and annuity withdrawals. Roth IRA withdrawals, life insurance policy loans, and interest from municipal bonds are some of the few forms of retirement income not subject to federal or state income taxes. Therefore, it’s worth pursuing an even mix of pre-tax and after-tax retirement investments for your nest egg.
Accounting for Inflation
Inflation is expected to remain relatively stable between now and 2060, rising approximately 2% each year. It’s worth keeping this information in mind as you invest for retirement. A 5-6% annual gain doesn’t seem as great when you account for expected inflation. When you calculate inflation into your retirement savings projections, a 401k might seem like a better alternative. You can save as much as possible before years of inflation rack up.
However, a Roth IRA could still outperform a 401k in this instance. This is because your future retirement fund is not subject to taxes and inflation, just inflation. This means your purchasing power will only be slightly diminished in retirement. A 401k is hampered by income taxes in distributions and inflation. It also negatively affects your Social Security tax rate and Medicare Part B premium costs.
Are 401k Accounts Really More Advantageous than Roth IRAs?
Although 401k accounts allow workers to contribute as much as $18,000 or $24,000 to their funds each year, most Americans fall short of these maximum limits. In fact, reports from Vanguard and Fidelity have shown the average worker making $30,000 annually contributes just 3.9% of their income to a 401k. Workers making $100,000 or more contribute just 8.1%.
If the average person saving for retirement doesn’t take advantage of the 401k maximum contributions, then do the pros of marginal income tax savings really outweigh the cons of taxation during retirement?
On the other hand, Roth IRAs offer many unique advantages that could protect your retirement nest egg over the long-term. Since you’re only taxed on contributions in the year you make them, a Roth IRA is essentially a tax-free growth account. To illustrate, here’s an example. A 28 year-old who starts saving $5,000 per year in a Roth IRA for 37 consecutive years will have about $857,000 by the time they reach 65, assuming a 7% rate of return. This equates to $565,000 in tax savings because you only really contributed $185,000 over those 37 years!
The best retirement planning strategy would incorporate both a 401k and a Roth IRA. By doing so, you’ll be able to maximize your long-term gains. You’ll also reduce your retirement tax burden, and get some current-year tax savings from your 401k deductions as well. We never know what income tax brackets and inflation rates will be 10-40 years in the future, but the math generally checks out for people who have both 401k and Roth IRA retirement accounts.