First thing I want to say is that it's very easy for technical people to frame this as a technical issue rather than an emotional issue. The evidence is overwhelming that wealth building is an emotional issue. So if you're not paying attention to that side of the equation, all this tax stuff really doesn't matter. I'll get back to this later and explain the four account types now.
Employer:
Traditional 401k (pre tax), Roth 401k (after tax)
Personal:
Traditional IRA (pre tax), Roth IRA (after tax)
These are tax designations, not investment types.
Roth means after tax dollars (more money up front). Traditional is pre tax dollars (you get pay more later). Both grow tax free, but with the traditional withdrawals count as income so they are taxed according to that tax year.
401k has a contribution limit is $18k / year.
IRA has a contribution limit of $5500 / year.
$23.5k / year total right now for somebody under 55.
If you make enough / spend little enough that you can put the maximum dollars under the shelter, my suggestion is to go Roth 401k and Roth IRA or backdoor IRA. Over a 30 year period, the additional dollars under Roth will make up for most tax percentage differences, so it's a decent bet. Roth is the best way to max dollars under the tax shelter, and the tax shelter is hugely profitable. Also, if you go Roth, your retirement balance will be the real balance, not some fake number that is still subject to unknown future taxation.
If you can't max the dollars, then it doesn't matter as much if you pick Roth or Traditional. Yes, you have to make a call about what tax rates will be now vs. in the future, but how much money you put into the account and if you stay steady with low cost investments will matter more. So I wouldn't focus on the tax issue. I'd focus on how you earn enough / spend less to be able to max both contributions so that the tax issue matters less than the opportunity cost of having investments outside the tax shelter.
If your employer doesn't offer a retirement plan, you can usually write off a traditional IRA contribution on your taxes. However, I'd recommend you do a Roth IRA instead or avoid this writeoff so that you can do the back door roth mentioned in the next paragraph.
If you make too much for a Roth IRA, you can do a back door roth ira.
Get a tax guy for this. It can get complicated the IRS is a headache. It's worth it to pay for a tax guy.
Do this by funding a traditional IRA then converting it to a roth IRA. The conversion has no income limit - that's why this is legally possible. This gets more complicated if you have traditional IRA money, because they don't let you pick which dollars you're converting. The cleanest way is to convert all of the money at once, but you will have a big tax bill if you do this, so you need the cash saved up OUTSIDE the account. If you pay the taxes with money from the account, there's no point doing it. When you convert it, it's counted as income -- you have to pay the taxes at your current tax rate, and that may bump you into a higher tax bracket, so you might not want to convert it all at once to avoid those higher taxes. If you know you're going to live in a lower tax state soon, it is probably wise to wait until you fall under the tax laws of that state to do the conversion... but remember ,this is most valuable while you're young, so when I say wait, I mean 2 years, not 20. It can be a hairy calculation. The taxes you pay are, in effect, shoving more money under the tax free growth umbrella.
Most 401ks offer mediocre to bad investment options. This sucks, but contribute anyway b/c the tax shelter is fabulous, and later you'll roll the money over into an IRA where you can pick good stuff. I suggest go an indexing route like Betterment.
Allright, so those are the tax mechanics. But they don't matter if you don't actually save the money, and saving the money is highly dependent on your emotions and habits.
- Do you have habits that are coping mechanism connected to spending?
- Are you surrounded by people in BMWs who make you feel poor?
- Do you regularly read about investing and spend time planning your investing?
- Do you have a plan for career advancement?
- Do you have mentors for career advancement?
- Do you keep a monthly budget and check your spending against your plans?
- Do you know your retirement date?
I'm asking all these things because they are more important than the (theoretical) mechanics of the money. Engineers love to believe a spreadsheet showing how their 30 year 4% mortgage is hedged well against their predicted 8% portfolio to make them an extra $150k over 30 years, but the truth is that Americans suck at saving and generally don't save, so the hedge never happens and the spreadsheet was a waste of time. Also, maintaining the mortgage can put enough pressure on someone that they keep the paycheck instead of starting a business, so he earned a fraction of what he would have if he'd tried a startup. The decision to lower financial risk to start a company has a hard-to-calculate gain. We tend to avoid it and instead focus on things we can calculate.
If you spend some time reading about personal finance and psych, you can learn how to be a happier person while spending less, and this will matter more for your retirement than 401k vs. IRA and Traditional vs Roth.
I recommend you invest some time and money in some good books / audio books. They will pay themselves back 1000X, literally.
1. Dave Ramsey's Total Money Makeover
2. The Millionaire Nextdoor (and the Millionaire Mind sometime later)
3. The Little Book of Common Sense Investing
4. http://www.mrmoneymustache.com/
5. http://earlyretirementextreme.com/
6. Predictably Irrational
7. The Power of Habit
Of course, tax sheltered retirement accounts aren't the only option planning for the future. But they are a decent insurance plan. As you read more about personal finance, you'll see some of the other options for your savings (education, business), and you'll have to make a call about how you want to spread your risk. good luck.
