The core concept
Retirement accounts are tax-advantaged structures that hold investments. The “account” isn’t an investment itself but rather a container with special tax rules. Inside that container, money can be invested in stocks, bonds, mutual funds, ETFs, and other assets.
The tax advantages come with restrictions, primarily that the money is intended for retirement. Early withdrawals typically trigger taxes and penalties. This trade-off, better tax treatment in exchange for reduced liquidity, defines all retirement accounts.
Understanding retirement accounts requires separating the container (the account type and its rules) from the contents (the investments held within). A 401(k) can hold the same mutual funds as a taxable brokerage account; the difference is how contributions and growth are taxed.
Traditional vs. Roth: The fundamental split
All retirement accounts follow one of two tax treatments:
Traditional (pre-tax): Contributions reduce taxable income in the year contributed. The money grows without being taxed annually. Upon withdrawal in retirement, the full amount is taxed as ordinary income.
Roth (after-tax): Contributions come from already-taxed income and don’t reduce taxable income. The money grows without being taxed. Upon withdrawal in retirement, nothing is taxed, including all the growth.
The question isn’t which is better universally. It’s whether paying taxes now (Roth) or later (Traditional) produces better outcomes for a specific person. That depends on current versus expected future tax rates.
Someone in a high tax bracket now who expects a lower bracket in retirement mathematically benefits from Traditional accounts, getting a large deduction now and paying lower taxes later. Someone in a low bracket now who expects higher income later benefits from Roth, paying minimal taxes now and avoiding higher taxes later.
In practice, future tax rates are unknowable. Tax laws change. Income in retirement varies. Having both Traditional and Roth accounts provides flexibility to manage tax liability in retirement by drawing from different pools.
401(k) accounts
The 401(k) is an employer-sponsored retirement plan. The name comes from the section of the Internal Revenue Code that authorizes it. Access depends on the employer offering one.
Contributions come from payroll deductions before paychecks are deposited. Electing a 10% contribution means 10% of gross pay goes to the 401(k) before federal income tax is calculated, reducing taxable income.
2025 contribution limit: $23,500 per year for those under 50. Workers 50 and older can contribute an additional $7,500 “catch-up” contribution, for a total of $31,000.
Employer matching is the feature that makes 401(k)s uniquely valuable. Many employers match employee contributions up to a percentage of salary. A common structure is 50% match on contributions up to 6% of salary: an employee earning $60,000 who contributes $3,600 (6%) receives $1,800 (3%) from the employer.
The match is free money with conditions. It typically vests over time, meaning employees must stay with the company for 3-6 years to own the matched funds fully. Unvested matches are forfeited upon departure.
Investment options are limited to what the plan offers, typically 10-30 funds selected by the employer. Quality varies considerably. Some plans offer low-cost index funds; others are filled with high-fee actively managed funds. Participants choose among available options but can’t invest in anything outside the menu.
Roth 401(k) options exist at many employers. Contributions go in after-tax (no current deduction), but qualified withdrawals are tax-free. The same contribution limits apply whether contributing Traditional, Roth, or a combination.
Withdrawals before age 59½ generally trigger a 10% early withdrawal penalty plus ordinary income taxes on the withdrawn amount. Exceptions exist for hardship withdrawals, though the penalty often still applies. Required Minimum Distributions (RMDs) begin at age 73, forcing withdrawals and taxation whether the money is needed or not.
Traditional IRA
The Individual Retirement Account is a personal retirement account not tied to an employer. Anyone with earned income can open one at a brokerage firm.
Contributions are made directly by the account holder, not through payroll. Contributing requires intentional action, unlike 401(k)s where payroll deductions happen automatically.
2025 contribution limit: $7,000 per year for those under 50, plus $1,000 catch-up for those 50 and older ($8,000 total).
Tax deductibility depends on income and access to employer retirement plans. Without a workplace retirement plan, Traditional IRA contributions are fully deductible regardless of income. With a workplace plan, deductibility phases out above certain income thresholds: for single filers in 2025, the phase-out range is $79,000-$89,000.
Investment options include essentially anything: individual stocks, bonds, mutual funds, ETFs, REITs, and more. The IRA holder chooses their brokerage firm and selects investments from that firm’s offerings. This freedom comes with responsibility; no employer vets the options.
Withdrawals follow similar rules to 401(k)s: 10% penalty plus taxes before age 59½, with some exceptions. RMDs begin at age 73.
Roth IRA
The Roth IRA follows IRA structure with Roth tax treatment: after-tax contributions, tax-free growth, tax-free qualified withdrawals.
2025 contribution limit: Same as Traditional IRA, $7,000 ($8,000 if 50+). The limit is shared between Traditional and Roth IRAs; someone can’t contribute $7,000 to each.
Income limits restrict Roth IRA contributions. For single filers in 2025, the ability to contribute phases out between $150,000 and $165,000 of modified adjusted gross income. Above $165,000, direct Roth IRA contributions aren’t permitted.
Backdoor Roth IRA is a workaround for high earners. It involves contributing to a Traditional IRA (no income limit for non-deductible contributions) and then converting to a Roth IRA. The conversion triggers taxes on any deductible contributions or gains, but subsequent growth becomes tax-free.
Withdrawal flexibility distinguishes Roth IRAs. Contributions (not earnings) can be withdrawn at any time without penalty or taxes since they were made with after-tax money. This makes Roth IRAs function as emergency backup funds while still providing retirement tax benefits on the earnings.
No RMDs during the original owner’s lifetime. Roth IRA money can stay invested indefinitely, making it useful for estate planning. Traditional IRAs and 401(k)s force distributions; Roth IRAs don’t.
SEP IRA and SIMPLE IRA
Self-employed individuals and small business owners access different retirement account types.
SEP IRA (Simplified Employee Pension): Allows contributions up to 25% of self-employment income, maxing at $69,000 for 2025. Only employer contributions are allowed (the self-employed person is both employer and employee). Easy to establish and maintain.
SIMPLE IRA (Savings Incentive Match Plan for Employees): For businesses with 100 or fewer employees. Employee contribution limit of $16,500 for 2025, plus employer match requirements. More complex than SEP but allows employee deferrals.
These accounts follow Traditional IRA tax treatment: deductible contributions, tax-deferred growth, taxed withdrawals.
How employer matching compounds
The power of employer matching becomes clearer over time. Consider an employee earning $80,000 with a 50% match on contributions up to 6% of salary:
- Employee contributes 6%: $4,800/year
- Employer matches 50%: $2,400/year
- Total annual contribution: $7,200/year
The employer match represents a 50% immediate return on the employee’s contribution before any investment growth. Over a 30-year career with 7% average annual returns:
- Employee’s contributions alone ($4,800/year for 30 years at 7%): ~$454,000
- Including employer match ($7,200/year for 30 years at 7%): ~$681,000
The employer contributions added $227,000 in final value. This doesn’t require investment skill; it’s the mechanical result of contributing enough to capture the full match.
Not capturing the full match, contributing less than the matched amount, leaves money on the table with no recovery possible.
How investment choice affects outcomes
The investments inside retirement accounts determine actual returns. A 401(k) isn’t automatically good; a 401(k) invested in high-fee, poor-performing funds grows slowly despite tax advantages.
Index funds tracking broad market indexes provide diversified exposure at low cost. A total stock market index fund in a 401(k) grows with the overall market minus minimal fees (often 0.03-0.20% annually).
Target date funds automatically adjust asset allocation based on expected retirement year. A 2055 target date fund holds more stocks now and gradually shifts toward bonds as 2055 approaches. These provide hands-off appropriate allocation but may have higher fees than building the same allocation from index funds.
Actively managed funds attempt to beat market indexes through stock selection. Most fail to outperform after accounting for their higher fees. The average actively managed fund in a 401(k) costs 0.50-1.50% annually, eating significantly into long-term returns.
Company stock is offered by some employers. Concentrating retirement savings in one company’s stock creates risk: if the company fails, both job and retirement savings disappear simultaneously.
The difference between 0.10% and 1.00% annual fees compounds dramatically. On a $500,000 portfolio over 20 years with 7% gross returns:
- 0.10% fee: ends at ~$1,867,000
- 1.00% fee: ends at ~$1,582,000
The higher fee cost $285,000 over 20 years, not through poor returns but simply through the drag of higher costs.
Withdrawal strategies
Taking money from retirement accounts in retirement involves strategic decisions about sequencing.
Traditional accounts trigger ordinary income taxes on withdrawals. Large withdrawals can push retirees into higher tax brackets. Spreading withdrawals over more years keeps income in lower brackets.
Roth accounts provide tax-free income, useful for years when additional Traditional withdrawals would trigger higher brackets, Medicare surcharges, or Social Security taxation.
Taxable accounts receive more favorable capital gains treatment than Traditional accounts. Strategic sequencing might involve spending taxable account money first, letting Roth continue growing tax-free, and managing Traditional withdrawals to stay in lower brackets.
The optimal strategy depends on specific circumstances: total balances in each account type, other income sources, state taxes, and desired legacy for heirs.
Common questions
Can I have both a 401(k) and an IRA?
Yes. The contribution limits are separate. Someone with access to a 401(k) can also contribute to an IRA, though the IRA deductibility rules apply based on income and 401(k) participation.
What happens to my 401(k) when I leave my job?
Options include leaving it with the former employer (if allowed), rolling it to the new employer’s plan, or rolling it to an IRA. Rolling to an IRA typically provides more investment options and lower fees.
Should I contribute to Traditional or Roth?
This depends on current versus expected future tax rates. Lower income years favor Roth (pay low taxes now). Higher income years favor Traditional (defer taxes to lower-income retirement years). When uncertain, splitting contributions provides future flexibility.
Is the employer match included in the contribution limit?
No. The $23,500 limit covers employee contributions only. Employer contributions don’t count against it, though combined contributions (employee + employer) are capped at $69,000 for 2025.