Tax Benefits Compared
Traditional IRA and 401k contributions are made with pre tax dollars, which reduces the current year tax bill. The money grows tax deferred, and the withdrawals in retirement are taxed as ordinary income. Roth IRA and Roth 401k contributions are made with after tax dollars, which does not reduce the current year tax bill. The money grows tax free, and the withdrawals in retirement are also tax free. The best choice depends on the current tax bracket and the expected tax bracket in retirement. Most financial advisors recommend a mix of traditional and Roth contributions to diversify the tax exposure across retirement years.
When to Prioritize the 401k
Prioritize the 401k when the employer offers a match, since the match is free money that is too valuable to pass up. A typical employer match is 50 cents to 1 dollar per dollar contributed, up to 3 to 6 percent of salary. A 100,000 dollar salary with a 3 percent match means the employer contributes 3,000 dollars per year, which over a 30 year career at a 7 percent return is worth 300,000 dollars. Prioritize the 401k also when the fees are low and the investment options are good, since high fees can erode returns by 0.5 to 1 percent per year, which is a significant drag on long term growth.
When to Prioritize the IRA
Prioritize the IRA when the 401k has limited investment options, high fees, or no employer match. Many small employer 401k plans have expensive target date funds or limited index fund options, and the fees can be 0.5 to 1.5 percent per year. IRAs at major brokerages offer a much wider selection of low cost index funds and ETFs, with expense ratios of 0.03 to 0.20 percent. The lower fees can add 0.5 to 1 percent per year to the long term return, which compounds into a significant difference over 30 years. Prioritize the IRA also when the investor is in a low tax bracket, since the Roth IRA offers a better long term tax outcome.
What About Catch Up Contributions
Both IRAs and 401ks allow catch up contributions for those 50 and older. The IRA catch up is 1,000 dollars, bringing the 2026 limit to 8,500 dollars. The 401k catch up is 2,000 dollars, bringing the 2026 limit to 32,500 dollars. The catch up is a great way for older workers to boost their retirement savings in the final years before retirement. The 401k catch up is also an opportunity for high income earners to reduce their current year tax bill, since the 401k contribution lowers the taxable income. Many financial advisors recommend maxing out the catch up for the final 5 to 10 years of working, since the late career savings are often the most impactful.
How to Decide Between the Two
Start with the 401k, contribute at least enough to get the full employer match, since the match is free money. Then max out a Roth IRA, since the IRA offers more investment options, lower fees, and tax free growth. Then go back to the 401k and increase the contribution. The exception is when the 401k has very high fees or limited investment options, in which case the IRA may be a higher priority. For self employed individuals, a SEP IRA or a Solo 401k is a better fit than a 401k, since the contribution limit is higher and the fees are lower. The most important step is to start saving as early as possible, since the power of compound interest is enormous over a 30 to 40 year career.
Photo: NASA, Public Domain (NASA), via NASA Image and Video Library (https://images.nasa.gov/details/KSC-2011-8301)
Fazlur Rahman
