Once upon a time, a pension and Social Security benefits were enough to cover expenses during retirement. Today, not so much. Instead, most people fund their own post-work years with various retirement plans that offer tax breaks and other benefits.

Here’s a look at different scenarios and factors to consider when you come to choose an investment account.

Roth IRA vs. Traditional IRA

Individual retirement accounts—or IRAs—are tax-advantaged accounts that hold the investments you choose. There are two main types of IRAs: traditional and Roth. You must have earned income—wages, salaries, and the like—to contribute to either.

The limits and the tax benefits for IRAs are set by the Internal Revenue Service (IRS). The contribution limits for traditional IRAs and Roth IRAs are the same. For 2022, you can contribute up to $6,000 a year plus an additional $1,000 if you turn 50 (or are older) by the end of the tax year.

You must take required minimum distributions (RMDs) from a traditional IRA, which are calculated annual withdrawals. The passage of the SECURE Act by the U.S. Congress increased the age of when you need to begin taking RMDs from 70½ to 72 years old as of 2020.

Conversely, Roth IRAs have no RMDs during the owner’s lifetime. That makes a Roth IRA a good wealth-transfer vehicle because you can pass the entire account—and its tax benefits—onto your heirs.

However, the IRS made changes to the required minimum distribution rules for designated beneficiaries following the death of the IRA owner after Dec. 31, 2019. All of the funds must be distributed by the end of the 10th year after the death of the IRA owner. There are exceptions for certain eligible designated beneficiaries, such as a spouse.

If you are eligible for both types of IRA, making the choice usually depends on when you want to pay taxes—now or in retirement.

Traditional IRA Income Limits

With a traditional IRA, you get an upfront tax break—you can deduct your contributions—but you pay taxes on withdrawals in retirement. One caveat: You can always deduct your contributions in full only if you and your spouse don’t have a 401(k) or some other retirement plan at work. Otherwise, your deduction could be reduced or eliminated, depending on your income.

Here’s a rundown of the 2022 contribution limits per the IRS:

Roth IRA Income Limits

With a Roth IRA, your contribution isn’t tax deductible, but qualified distributions are free of taxes and penalties. What constitutes “qualified”? It must be at least five years since you first contributed to a Roth, and one of the following must also hold true:

• You have reached the age of 59½.
• You have a disability.
• You are using the distribution to buy a first home (lifetime limit: $10,000).
• You have died (and your beneficiary receives the distributions).

Unlike traditional IRAs, Roth IRAs have income limits for contributions. In short, if you make too much money, you can’t contribute to a Roth. The limits are based on your modified adjusted gross income (MAGI) and your filing status:

There is, however, a backdoor way to contribute to a Roth IRA if you are above that income limit. To help you decide which IRA to invest in, look at your current tax bracket compared to your projected tax bracket during retirement. Try to choose which plan results in lower taxes and more income (granted, determining this may not be easy).

In general, a Roth is the better choice if you expect to be in a higher tax bracket in retirement, or if you expect to have significant earnings in the account. As long as you take qualified distributions, you won’t ever pay taxes on earnings.

401(k) Plans

Like IRAs, 401(k) plans are tax-advantaged accounts used to save for retirement. But instead of being set up by individuals (that’s the “I” in IRA), they’re offered by employers.

Note that 401(k)s are defined contribution plans. Employees make contributions to their 401(k)s through automatic payroll withholding. And the employer can add money, too, through something called an employer match.

For example, your employer might contribute up to 5% of your salary—as long as you put in at least that amount yourself. If your employer offers a match, do everything you can to max out your contributions to get that match—it’s essentially free money.

401(k) Contribution Limits

For 2022, you can contribute up to $20,500 to your 401(k), or $27,000 if you’re age 50 or older (because of a $6,500 catch-up contribution).

Employers can contribute, too. For 2022, there’s a $61,000 limit on combined employee and employer contributions, or $67,500 if you’re age 50 or older.

These high contribution limits are one advantage that 401(k)s have over traditional and Roth IRAs.

What if You Can Contribute to a 401(k) or an IRA?

It may be that you are eligible to make traditional IRA or Roth IRA contributions as well as salary deferral contributions to a 401(k) plan. But you may not be able to afford to do both.

You must decide what is most beneficial to you—to make one, two, or all three work. Some of the following concepts can also apply if you have the option of contributing to both a traditional 401(k) and a Roth 401(k).

Let’s look at River, who works for Company A and is eligible to make a salary deferral to Company A’s 401(k) plan. River’s annual compensation is $50,000, and they can afford to contribute $2,000 each year, which they have decided to put into one account to avoid excessive fees. Therefore, River must decide whether it makes better financial sense to contribute to the 401(k) or to an IRA.

If there is a company match

If Company A provides a matching contribution on River’s salary deferral contributions, the 401(k) will be the better choice. Below is a look at the growth of their accounts over a 10-year period, assuming an employer match of $1 for each $1 River contributes, for up to 3% of their salary.

This means that River will receive a matching contribution of $1,500 ($50,000 x 3%). In 10 years, their 401(k) would grow significantly faster than an IRA.

If there isn’t a company match

If Company A isn’t making matching contributions to the 401(k) plan it offers, River should consider the following questions before deciding whether to invest in the 401(k):

Which investment choices are available? Large corporations typically limit investment choices to mutual funds, bonds, and money market instruments. Smaller companies may do the same but are typically more likely to allow self-direction of investments.

That means participants can choose from stocks, bonds, mutual funds, and other available investments, similar to the investment options available in a self-directed IRA. If investments in the 401(k) are limited, River may do better if he contributes to an IRA, which would provide a broader range of investment choices.

What are the fees? One hot-button issue is the fees that are charged to 401(k) accounts. These are not as visible as the fees that are charged to an IRA, leading many participants to believe that 401(k) fees are minimal to nonexistent. Not true.

River would need to research the fees that apply to their company’s 401(k) plan and compare them with the operational and trade-related fees that apply to the IRA.

Are the 401(k) funds accessible? Though retirement savings are intended to accumulate until retirement, situations sometimes arise that leave a participant no choice but to make withdrawals or take out a loan from their retirement accounts.

Generally, assets in a 401(k) plan cannot be withdrawn unless the participant experiences a triggering event. However, if Company A’s plan has a loan feature, River could take a loan from their account and repay it within five years (or longer, if the loan is for the purchase of a principal residence).

IRA assets can technically be withdrawn at any time. However, if you’re under the age of 59½, your distribution will be considered taxable income, and it may be subject to a 10% additional tax (or penalty). However, except for a rollover contribution, the amount cannot be repaid to the IRA.

What’s the cost of professional management? If River isn’t proficient in investment management or doesn’t have the time to properly manage their plan investments, they may need the services of a professional investment advisor. That person could make sure their asset allocations are consistent with their retirement goals and objectives.

If River’s employer provides those services as part of its employee benefits package, River won’t incur an additional cost to have a professional manage his investments. This perk may not be available for an IRA unless an employer extends such services to assets outside of its employer-sponsored plan.

These points are worth considering, even if matching contributions are made to the 401(k) account. But without a match, the answers to these questions may lead River to conclude that the savings benefits of an IRA outweigh those of a 401(k).

What about tax deductions? Contributions to a 401(k) reduce taxable income. So do contributions to a traditional IRA—but those employed by a company with a retirement plan, like River, are subject to income limits on how much of the contribution is deductible, as noted above.

And of course, contributions to a Roth IRA are not tax deductible at all; the benefit of a Roth IRA is that withdrawals at retirement are not taxed, unlike withdrawals from a traditional IRA or 401(k). Figure out how important getting a tax deduction this year is when choosing among retirement plans.

What if You Could Contribute to a 401(k) and an IRA?

Now, let’s take a look at TJ, who can afford to fund her 401(k), a traditional IRA, and a Roth IRA. If TJ can afford to contribute the maximum to all their accounts, then they may have no need to be concerned with how to allocate their savings.

But let’s assume TJ can afford to save only $7,000 for the year. The points of consideration for River (above) may also apply to TJ. In addition, TJ may want to consider the following:

Getting the maximum match

If a matching contribution is made to the 401(k) plan, consider the maximum amount they need to contribute to the plan to receive the maximum available matching contribution.

For example, assume TJ’s compensation is $80,000 per year, and the match is $1 for $1 for up to 3% of compensation. They will need to contribute at least $2,400 to their 401(k) plan to receive the maximum available matching contribution of $2,400.

Choosing between IRAs

If TJ puts $2,400 into their 401(k), they’ll have $4,600 of savings left for their IRA contribution. TJ will have to do the math (or check with a tax advisor) to find out how much of their traditional IRA contributions would be tax deductible and factor that into their decision to choose a Roth IRA, a traditional IRA, or a combination of the two.

Whatever TJ decides, their total contributions to both IRAs cannot exceed the limit for that tax year.

Which to fund first

It is usually best to make contributions to the retirement accounts early in the year, or a little each month; beginning early in the year so that the assets can start accumulating earnings as soon as possible.

Consider how matching contributions are made, too. Some companies contribute the amount in one lump sum at the end of their tax-filing deadline, while others contribute amounts throughout the year. If the latter applies, it’s better to make salary deferral contributions to the 401(k) early in the year.

Setting Up a Backdoor Roth IRA

High-income earners can’t contribute directly to a Roth IRA. But thanks to a tax loophole, they can make contributions indirectly and access a Roth that way. Using this strategy, taxpayers can save tens or even hundreds of thousands of dollars on taxes over the years.

A traditional IRA, on the other hand, doesn’t limit or prevent people with higher incomes from contributing. The backdoor Roth takes advantage of this fact, and you can contribute to one yearly. The steps to take:

Step 1: Contribute to a traditional IRA. There are no income limits for making this contribution—and it may already be after-tax money if your income is above the limits.

Step 2. Immediately convert your traditional IRA to a Roth IRA. Ideally, do this before your traditional IRA contribution has generated any earnings that will have to be taxed when you do your conversion.

Step 3. Follow the tax rules. If you took a deduction on your pre-tax contributions from your traditional IRA, you will owe taxes when you convert them to a Roth IRA, which is funded with after-tax income.

If you were unable to deduct your traditional IRA contribution (see step 1), you won’t owe further taxes except on any earnings (if your conversion happened after your contribution generated income.).

However, if you have other money in traditional IRAs, there is a pro rata rule about how you are taxed on a Roth IRA conversion. This is not a DIY problem: Consult a tax advisor before doing your conversion.

Mega Backdoor Roth Contribution

If your employer permits traditional 401(k)s to be rolled over to either your company’s Roth 401(k) plan or to an outside IRA, you may be in a position to move a considerable amount of money into a Roth account where it can grow tax-free and provide tax-free distributions at retirement. This strategy requires sophisticated advice about what you might owe in taxes.

Other Points to Consider

In addition to the points listed above, you should consider other factors, such as:

Age and retirement horizon

Your retirement horizon and age are always important points of consideration when determining proper asset allocation. However, if you are at least age 50, participating in a plan that includes a catch-up contribution feature can be an attractive choice, especially if you are behind in accumulating a retirement nest egg.

If that describes you, choosing to participate in a 401(k) plan with a catch-up feature can help to add larger amounts to your nest egg each year. IRAs have catch-up features, too, but you can add only $1,000, not $6,000, to your contribution.

Purpose of funding a retirement account

Though retirement accounts are usually intended to finance your retirement years, some people plan to leave these accounts to their beneficiaries.

In that case, you have to think about whether you want to leave tax-free assets to your beneficiaries, and whether you want to avoid having to take RMDs that will lower the balance in your accounts. Roth IRAs and Roth 401(k)s allow you to pay taxes when you make the initial contributions. For Roth IRAs, the RMD rules do not apply to the IRA owner, which allows for a larger balance to be left to beneficiaries.

Certain government entities offer special retirement plans for employees.

The Bottom Line

For those who are eligible to fund multiple types of retirement accounts and have the money to fund them all, the choice is not an issue. For those who don’t have money to fund multiple accounts, picking the best option(s) can be challenging.

In many instances, it boils down to whether you prefer to take the tax breaks on the back end with Roth IRAs, or on the front end with traditional IRAs. The ultimate purpose of the account, such as retirement versus estate planning, is also an important factor. A competent retirement planning advisor can help people facing these issues to make practical choices.