Chapter 16: The account alphabet: 401(k), IRA, Roth
The single most common beginner question is some version of "should I buy a 401(k) or an index fund?" It has no answer, because it's like asking "should I buy a lunchbox or a sandwich?" One sentence clears it up: an account is a wrapper; an investment is what goes inside it. A 401(k), an IRA, and a Roth are all tax wrappers. The index fund from Chapter 13 is what you put in them. Same sandwich, different lunchbox, very different tax bill.
The wrappers and their 2026 limits
A 401(k) (or 403(b), 457, TSP) is a retirement wrapper run by your employer; money goes in from your paycheck. An IRA (individual retirement account) is one you open yourself at any brokerage. Each comes in two tax flavors, traditional (tax break now, taxed later) and Roth (taxed now, tax-free later), and each has an annual contribution limit:
| Wrapper | 2026 employee limit | Catch-up |
|---|---|---|
| 401(k) / 403(b) / 457 / TSP | $24,500 | +$8,000 at age 50+; +$11,250 at ages 60–63 |
| IRA (traditional + Roth combined) | $7,500 | +$1,100 at age 50+ |
One more 2026 number: direct Roth IRA contributions phase out between $153,000–$168,000 of income for single filers and $242,000–$252,000 for joint filers. Above that, the front door is closed, but there's a legal back door we'll walk through below.
First move, always: capture the match
Many employers add money when you contribute, say 50 cents per dollar on your first 6% of salary. That employer match is the highest guaranteed return in all of personal finance, which is why it sits at step 2 of the order of operations in Chapter 4, ahead of almost everything.
Jamie contributes nothing and leaves the full employer offer on the table.
Jamie puts in 6% of $90,000 ($5,400); the 50% match adds $2,700, an instant 50% return before the market does anything.
No investment, no harvesting trick, nothing in Chapter 15 comes close to an instant 50%. Check your plan's vesting schedule (when matched money becomes truly yours), but contribute to the match line first.
Traditional or Roth: pay tax now, or later?
Both wrappers shelter growth completely while the money is inside. The only difference is when you pay tax:
- Traditional: contribute pre-tax (saving tax at your marginal rate today), pay ordinary income tax when you withdraw.
- Roth: contribute after-tax (no break today), pay nothing when you withdraw, growth included.
The decision comes down to one comparison: your marginal rate now vs. your marginal rate when you withdraw. Run $10,000 of salary through both at the same 24% rate: traditional invests the full $10,000, it triples to $30,000, tax at withdrawal leaves $22,800. Roth pays $2,400 tax first, invests $7,600, triples to $22,800, tax-free. Identical. The order of taxation doesn't matter; the difference in rates decides everything. Withdraw at 12% instead and traditional leaves $26,400, so it wins. Pay only 24% now but face 32% later, and Roth wins.
So the practical guide: in unusually high-earning years, favor traditional, since you're dodging a high rate. In low-earning years (early career, sabbatical), favor Roth, since today's tax is cheap. If you're unsure, split between both; that diversifies you against future tax law. And one trap: never compare your average (effective) rate today to anything. Contributions escape tax at your top marginal rate; the comparison is marginal-to-marginal, in withdrawal terms (Chapter 15 has the full distinction).
Two more differences worth knowing. These wrappers are built for retirement: pull money out before age 59½ and you'll usually owe tax plus a 10% penalty, with specific exceptions, so the house fund and the emergency reserve don't belong here. And Roth IRAs come with two quiet perks: the dollars you contributed (not the growth) can come back out anytime without tax or penalty, and Roth IRAs have no required minimum distributions during your lifetime, unlike the withdrawal clock that starts at 73 or 75 for traditional accounts (Chapter 24).
Capture the full employer match before anything else. Then choose traditional when today's marginal rate is unusually high, Roth when it's unusually low, and a mix when you honestly don't know.
Try your own rates above; the crossover point is usually closer than people expect.
Know your workplace plan
- Match formula and the contribution needed to max it
- Vesting schedule: what's yours if you leave next year?
- Fund menu and expense ratios (Chapter 13's fee math applies double here)
- Roth 401(k) option?
- After-tax contributions allowed? In-plan Roth conversion? (the mega backdoor ingredients)
- Loan rules, and what happens to a loan if you quit
- Beneficiaries named and current (they override your will; see Chapter 10)
The backdoor Roth and the pro-rata trap
High earners locked out of direct Roth contributions can still get there legally: contribute $7,500 to a traditional IRA without taking a deduction (a nondeductible contribution, which anyone with earned income can make at any income), then convert it to a Roth IRA, and report both moves on Form 8606. If you have no other pre-tax IRA money, the conversion is nearly tax-free, since you already paid tax on the $7,500.
The trap is the pro-rata rule: the IRS treats all your traditional IRA dollars as one pot. You can't convert just the after-tax spoonful; every conversion is sampled proportionally from the whole pot.
Maya earns far past the Roth phaseout, so she tries the backdoor: a $7,500 nondeductible contribution, then a conversion. But she also has a $93,000 pre-tax rollover IRA from an old job. Her pot is now $100,500, of which $93,000, about 92.5%, is pre-tax. So 92.5% of her $7,500 conversion, about $6,940, is taxed as ordinary income; at her 35% marginal rate that's roughly $2,430 in surprise tax. The fix: first roll the $93,000 into her current 401(k) (which accepts rollovers and only takes pre-tax money). With her IRA balance at zero on December 31, the same conversion becomes almost entirely tax-free.
The mega backdoor Roth
Some 401(k) plans accept after-tax contributions beyond the $24,500 employee limit and allow in-plan Roth conversion. Both features together let high savers move tens of thousands extra into Roth each year. Check the two boxes on your plan checklist above; without both, there is no mega backdoor.
Rollovers: compare, don't default
When you leave a job you can usually keep money in the old 401(k), roll it to the new one, or roll it to an IRA. None is automatically right. Compare fees and fund menus, remember that an IRA rollover can poison future backdoor Roths (Maya's trap above), and note that 401(k)s sometimes carry stronger legal protections. Moving money is fine; defaulting without comparing is how people end up in high-fee IRAs sold to them in a hallway.
Where people go wrong
- Contributing to the wrapper but never investing. Money in a 401(k) or IRA can sit in cash for years. Open the account, then buy something (Chapter 11).
- Skipping the match while paying extra on 5% debt. The match is an instant 50–100%; the order of operations (Chapter 4) puts it ahead.
- Comparing average-now to marginal-later. Apples to apples or don't compare.
- Backdoor converting with a pre-tax IRA sitting in the background. The pro-rata rule doesn't care which dollars you meant to convert.
Key takeaways
- Accounts are wrappers; investments go inside them. Decide both.
- 2026 limits: $24,500 for a 401(k) (+$8,000 at 50+, +$11,250 at 60–63); $7,500 for IRAs (+$1,100 at 50+). Roth IRA front door phases out at $153,000–$168,000 single / $242,000–$252,000 joint.
- The employer match is an instant 50–100% return. Capture all of it first.
- Traditional vs. Roth is one bet: marginal rate now vs. marginal rate at withdrawal. In a high year, traditional; in a low year, Roth; unsure, both.
- The backdoor Roth works, but the pro-rata rule taxes conversions in proportion to all pre-tax IRA money, so clear the pot first (often by rolling into your 401(k)).
Sources: IRS: 2026 Tax Inflation Adjustments · IRS: Publication 590-A, IRA Contributions · IRS: Publication 590-B, IRA Distributions · Tax Foundation: 2026 Tax Brackets