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Nov. 23, 2021, 7:10 p.m. EST

Should I use a 401(k) or an IRA to save for retirement? A traditional account or the Roth version? Here’s what to know

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By Alessandra Malito

You can save on taxes while saving for retirement by using an IRA or a 401(k). But deciding the best account is not always straightforward. There’s also the Roth option for both, meaning four choices, all with different rules.

Here’s how to figure it out. And remember this is money you’re setting aside for retirement, not to buy a house or pay for some other big expense. In fact, you generally can’t use it before age 59 ½ without paying a 10% penalty.

Be aware that there are plenty of rules with these accounts, and they can change. So check with the investment firm handling your account before you do anything rash.

Do I want an IRA or 401(k)?

If you have access to a 401(k) plan through your job, this is the one to pick. You can set aside more money than with an IRA and, also unlike an IRA, there’s no income limit for claiming the tax break. 

It’s an even better deal if your employer offers some sort of company match. Aim to at least put in whatever amount qualifies under those terms, and increase the amount over time. The total amount you can put in changes each year, but in 2022 it will go up $1,000 to $20,500 ($27,000 for those 50 and older.) The employer match is on top of this. Your employer will also offer a limited number of mutual funds that you can choose from.

If you don’t have a 401(k) at work, look at an IRA, or an individual retirement account. This is less generous, and it starts with the amount you can put into an account; up to $6,000 in 2022, plus an additional $1,000 for a total of $7,000 for people 50 and older, unchanged from 2021. You can only use earned income (rental income as well as dividends and capital gains don’t count), but you can pick any fund you want.

Investors who are not covered by a retirement plan at work can put in the full amount. 

People who have a retirement plan at work must meet income limits if they want a tax break, and that changes annually ( this is what it was in 2021 and what it will be in 2022 ). If you are one of those and given the restrictions, you probably want to put in as much as you can in that 401(k) plan before you even think about an IRA.

You can contribute to a spouse’s IRA as long as you file taxes jointly. If one of you doesn’t have access to a 401(k), you may want to look into this option.

If you are one of the relatively few who do hit the limit on 401(k) contributions and have more to invest, then you can think about an IRA, even when you won’t get a tax break.

Why would you do that instead of putting money in a regular brokerage account, where there’s no penalty for early withdrawal and you’d pay capital-gains taxes instead of income taxes? Three reasons: protections from creditors (think lawsuit or bankruptcy) up to $1 million, tax-free growth until you withdraw the money, and what’s called a backdoor Roth. We’ll get to that last one in a bit.

What about a traditional or Roth account?

Here’s where we get into the tax wrinkles.

With a traditional IRA or 401(k) you put money in before you’ve had to pay federal and state income taxes, but you’ll pay income taxes when you take out the money. With the Roth version, you are investing money after taxes have been paid but you withdraw it tax-free in retirement. 

Which makes more sense? It depends on your tax bracket today and in the future. Admittedly, that last part involves a lot of gazing into a crystal ball (how much income will you have in retirement? How will Social Security be taxed? And what will happen to tax rates?), so it’s a bit of a gamble.

Read: 37 states don’t tax your Social Security benefits — make that 38 in 2022

As a rule of thumb, Roth accounts may make more sense for people just starting out in their careers, when their salaries — and tax brackets — are relatively low. They may also work when workers are having a lower-than-usual earnings year, such as business owners who suffered a drop in sales. 

Not every company that offers a 401(k) plan also offers the Roth version, though they have become more widely available in the last decade. So you might not even have to consider this.

Then there’s the Roth IRA option. Like a Roth 401(k) account, it offers no immediate tax breaks. 

The contribution limits are the same as with a traditional IRA (and you can’t double dip; it’s the limit for IRAs and Roth IRAs combined). The income limits are more generous than for those qualifying for tax breaks with contributions to a traditional IRA, but they’re still a constraint.

Roth accounts are recommended for investments like stocks or even alternative investments because big gains won’t be taxed. In an extreme version of this, Peter Thiel, co-founder of PayPal /zigman2/quotes/208054269/composite PYPL +3.31% , turned his $2,000 Roth IRA in 1999 to $5 billion two decades later. 

Equally, don’t put already tax-advantaged investment like municipal bonds in a traditional IRA or 401(k).

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