Retirement savings vehicles: The basics

If you do any reading about retirement plans, you’ll often see terms like Traditional IRA, Roth IRA and 401(k) thrown around with carefree abandon. But what do they mean? Here we explain some of the differences.

An initial glance at the three plans reveals similarities. All three are retirement investment vehicles, designed to help you grow your money as you approach your golden years. Traditional and Roth IRAs are usually offered through financial services companies, like Voya. This means you have some flexibility to choose where your money is invested. To be eligible for either one, you simply have to be under the age of 72 and earning some sort of income. A 401(k) is offered through your employer, so you will likely have fewer choices in the investments. But as long as your employer offers a plan, you’re eligible. There are also many differences:

How much can you invest?

In a Traditional IRA, you can invest $6,000 annually if you’re 49 or under, and $7,000 if you’re older. You can invest the same amounts into a Roth IRA, but there are income caps. For tax year 2022 — if you’re single and earn between $129,000 and $144,000 or married and earn between $204,000 and $214,000 per year, your upper limits may be less. If you earn more than this, you can’t invest in a Roth IRA at all. With a 401(k), you can invest up to $20,500 a year and $6,500 for catch-up contributions.*

Are there any tax breaks?

With a Traditional IRA, your contributions can be tax-deductible, depending on your income level and access to employer-sponsored retirement plans. 401(k)s also offer tax-deductible contributions. With a Roth IRA, your contributions aren’t tax deductible, but if you’ve had the account more than five years and are 59½ or older, you can withdraw your money income tax-free.

Can you withdraw without a penalty?

With a Traditional IRA and 401(k), you can start withdrawing at your discretion at 59½. Withdrawals become mandatory at age 72. The money you withdraw is viewed as income, so it’s taxed. If you withdraw early from your Traditional IRA or 401(k), you can face a 10% penalty on top of the taxes levied. A Roth IRA can offer more flexibility. If you’ve had the account more than five years, you can start withdrawing any time so long as the withdrawals don’t exceed the value of your contributions, and you can start drawing the investment gains at age 59½. A Roth IRA carries a 10% penalty if you withdraw before five years, but after that you can withdraw your money free of penalties or taxes.

Weighing them up

At first glance, IRAs can offer great flexibility. But the 401(k) has a knockout punch, in that many employers offer matching contributions. This is essentially free money, which you won’t want to pass up. But that doesn’t mean a 401(k) wins outright. In fact, a good retirement strategy often uses a mix of different plans. Talk to your financial professional to see which ones could work for you.