Ep.75- 401K vs. IRA vs. Roth IRA vs. Regular Investments - What's Best For Retirement?

Read Time: 7 Minutes.

If you are reading this, you are probably wondering what’s the best strategy to save for your retirement. Before anything, you should understand the 4 most common types of savings vehicles (a fancy way to say ways of retirement savings): 401k/403b, IRA, Roth IRA, and Regular Brokerage Investments.

WHAT ARE THESE 4 ACCOUNTS EXACTLY?

  1. 401k (or 403b): 401k is for private companies and 403b is for non-profits. They work the exact same way. They are both tax-deferred savings accounts. In layman’s terms, it’s beneficial because you don’t pay income taxes when you contribute to a 401k or a 403b. You pay later.

    • A lot of people believe you never have to pay taxes on these investment. That’s not true. It’s deferred, meaning you will have to pay when you withdraw from it, typically starting 59.5 years old.

    • The single best feature of this account is the company match. Typically, a company matches a certain percentage based on your contribution. For example, a typical one could be 50% match up to 6% of your base pay. In other words, you can get a max match of 3% of your base pay (6% x 50%), if you contribute 6%.

    • The maximum contribution in 2019 is $19,000 per person. It goes up a little every year.

  2. IRA: An IRA (also known as a traditional IRA) account works exactly the same as a 401k or a 403b account, but worse, because there’s no company match and there’s a much lower contribution limit. Just like a 401k, it’s a tax-deferred savings account, where you don’t pay income taxes when you contribute. You pay later.

    • There is no company match for a traditional IRA account, because it is not a company sponsored account.

    • The maximum contribution in 2019 is much lower, at $6000, merely 1/3 of a 401(k) account.

    • The benefit is eliminated for high income earners ($137k for single, and $203k for a married couple).

  3. Roth IRA: Think about an IRA account, it’s the exact opposite. You DO pay income tax on this contribution, just like the rest of your regular income. But you don’t pay taxes when you withdraw at retirement.

    • How is it better than investing with regular income? You don’t pay tax on capital gains, meaning if your investment goes from $1,000 to $2,000, you don’t have to pay any tax on the gain of $1,000 ($2,000-$1,000).

    • There’s no company match at all.

    • Just like an IRA account, the maximum contribution is also $6,000 in 2019.

    • The benefit is eliminated for high income earners ($137k for single, and $203k for a married couple).

  4. Regular After-Tax Investment: It means opening up an investment account with a brokerage firm, such as Ameritrade, Fidelity, or Robinhood. It is a last resort retirement investment strategy, because it is not tax-efficient. The only thing worse than this, is to not save for retirement at all.

    1. Why is it the worst? You end up paying taxes in the beginning and at the end. In layman’s terms, you pay income tax on it on pay day, and you end up paying taxes (either regular income tax or capital gains tax, depending if hold your investments +1 year) again once you withdraw from it.

    2. There’s no match. It is just your own savings.

    3. There’s no limit on this, because there’s no tax advantage at all.

GENERAL RULE OF THUMB

I understand other people may have different opinions on this, specifically on the benefits of an Roth IRA. Generally, this is what I think the priority should be when it comes to optimizing my own retirement savings. In a later article, I will capture thew few exceptions where a Roth IRA account is better than a 401k account. For now, this is all you need to know.

retirement rule of thumb.png

YOUR OPTIMAL STRATEGY DEPENDS ON YOUR INCOME LEVEL

  1. Lower and Middle Class Retirement Strategy - Maximize 401K Match

    • The Why:If you only have a limited amount of income to spare for retirement savings, and you have access to a 401k/403b account through your employer, the best strategy is to maximize your company match. Why? It’s FREE money.

    • How it works: Find out what your company match is. It could be 50% match up to 6% in company 1, or 25% match up to 8% at company 2, or 100% up to 5% at company 3. Pay attention to the second number, which are 6%, 8%, and 5% respectively. You want to contribute at 6% at company 1, 8% at company 2 and 5% at company 3, so you are not leaving anything on the table.

  2. Upper-Middle Income Retirement Strategy - Maximize 401k Contribution & IRA

    1. The Why: At this income level (up to $137k for single, and $203k for married couple), you can take advantage of both a 401k account and an IRA account, because over these income thresholds, an IRA account becomes the same as regular after-tax retirement savings, as you no longer receive the tax advantage at contribution.

    2. How it works: If your situation allows, maximize your 401k contribution ($19k/yr in 2019), and IRA contribution ($6k/yr in 2019), as both are tax-deferred. If you are married, the two of you should maximize at twice the speed ($38k/yr for 401k + $12k/yr for IRA).

  3. High Income Retirement Strategy - Max 401k + Brokerage Investments + Home Ownership

    1. The Why: At this income level (> $137k for single or >$203k for married couple), you no longer qualify for any tax benefits from either an IRA account or a Roth IRA account, therefore leaving you only 401k and regular brokerage investment.

      1. Regarding regular brokerage investments, you should hold any investment for at least 1 year, so your gains will be taxed as a lower capital gains rate, instead of your income tax rates. Long terms capital gains tax is always lower than income tax at any income level.

      2. On top of that, buying a house above a certain price can still help, because all the deductions will help you push above the standard deduction limit of $24,000 (married couple). What’ the house price that can help you get there? Typically if you buy a house that costs more than $450k, and have a mortgage of $400k, you will get there, specifically because of these three deductions : mortgage interest deduction, property tax deduction, and your state income tax deductions. Once these three help you get over $24,000, you will be able to itemize and deduct more from taxes, thus saving more. Please note, in 2019, the combination of state income tax deduction and property tax deduction are capped at $10,000, even if the sum is much higher for you.

    2. How it works: If your situation allows, maximize your 401k contribution ($19k/yr in 2019), buy a house that’s at least $450k ( and ensure your mortgage is at least $400k). Lastly, if you still have extra income to put away into a brokerage investment, make sure you hold any investment for at least a year, so you can qualify for long term capital gains tax.