Comparing a 401(k) vs Roth IRA is a serious undertaking since your choice has a huge impact on your retirement investments. Take some time to explore their definitions, as well as their benefits and disadvantages. In the end, you can decide for yourself the best place for your hard-earned income.
In this article:
- What Is a 401(k)?
- What Is a Roth IRA?
- 401(k) vs IRA: Know the Downsides
- How to Maximize Your 401(k) and Roth IRA
401(k) vs Roth IRA | Where Should You Place Your Retirement Savings?
What Is a 401(k)?
To properly compare 401(k) vs Roth IRA, it’s essential to know what each means. A 401(k) is an employer-sponsored retirement plan. (Although self-employed individuals can have something similar called solo 401(k).) The company can set the guidelines for employees as long as they follow a certain standard. On the other hand, employees need to meet certain eligibility requirements.
To save, most of these plans use money from pre-tax income. In the process, it lowers your current tax liability. For each paycheck, your employer transfers a portion to your 401(k) account, which you and the company can invest in different portfolio types. This will allow the money to grow over time until you’re ready for retirement.
In addition to the employee’s personal contributions, there are different ways to fund the plan. One of the most popular is the matching contribution. It means that your employer will put in money each time you do. In some cases, it can be dollar for dollar, which effectively doubles your contribution.
There’s also a profit-sharing option. The company puts in their share only when they make a profit. The other one is non-elective, which means the business already sets a certain percentage of its contribution. All employees receive it regardless of how much they put into their 401(k) plan.
Sometimes, to protect themselves, employers may have a vesting schedule. Although the money is already in your account, they may still own a part or all of it, depending on the schedule. The good news is most of them are 100% vested.
Benefits of 401(k) Plan
When it comes to a 401(k) vs Roth IRA, consider the former if you are looking for the following benefits:
- The money is taken directly out of your paycheck, making it easier to save.
- Employers often match contributions, increasing your return on investment immediately.
- You can customize your investment objectives.
- You don’t personally have to manage your investments, which saves you time.
- The 401(k) plan has a higher contribution limit than a Roth IRA. As of 2018, employee contribution is $18,500 if you’re 49 years old or younger. The total maximum contribution, employee and employer together, is $55,000.
- Once you’re 50 years old, you can make an additional 401(k) catch-up contribution of up to $6,000 annually to further boost your retirement fund.
- You can consider early retirement and start withdrawing from your funds at 59.5 years old without incurring penalties.
- You can make hardship withdrawals or take loans from your 401(k) without penalty.
- When you want to transfer to another job, you can bring your plan with you (if it allows you to do so) or leave it to your employer. You can also take a lump sum amount or roll it over to an IRA.
- The employer cannot use a 401(k) to discriminate workers or keep highly compensated employees. They need to go through an assessment annually because of that.
What Is a Roth IRA?
You already know the basics of a 401(k) plan. Now learn about another retirement option called a Roth IRA.
A Roth IRA is just one of the many types of individual retirement accounts (IRAs). However, this and the Traditional IRA are the most popular.
The purpose of an IRA is to give you tax breaks. Unlike 401(k) plans, which are usually funded by pre-tax dollars, Roth IRAs use money from the after-tax income. In other words, you cannot reduce your tax liability at the time of contribution with the amount, but you don’t have to worry about paying taxes whenever you take a qualified distribution.
Benefits of Roth IRA
When it comes to 401(k) vs Roth IRA, the latter has the following advantages:
- A Roth IRA gives you a place to save in addition to your 401(k).
- You can withdraw your contributions at any time without paying a penalty or tax as long as you do so after you’re 59.5 years old.
- All your earnings in the account are tax-free.
- You can make an additional contribution of $1,000 per year after the age of 50 years.
- Although you can’t contribute to a Traditional IRA if your employer offers a 401(k), you can do so with a Roth IRA as long as you meet the income requirements.
- You can leave money in your Roth IRA and pass it to your heirs later.
- You can make contributions even if you’re 70.5 years old and above.
401(k) vs IRA: Know the Downsides
Although both types of accounts have a host of benefits, they also have downsides. Understanding the disadvantages should help you refine your retirement savings strategy.
With a 401(k), the following may be disadvantages:
- There are limits on withdrawing your money early.
- Upon retirement, you have to pay taxes for your withdrawals and earnings.
- Once you reach 70.5 years, you may have to make mandatory distributions (withdraw money from your account).
- Administrator fees can be high, and the vast majority of investors don’t even know they are paying such on their 401(k) accounts.
- Your account is through your employer, which is not ideal if you switch jobs often.
On the other hand, if you have a Roth IRA, you may encounter the following challenges:
- You have to set up the investment on your own.
- The Roth IRA limits are much lower than those of a 401(k) plan. As of 2018, you can only contribute up to $5,500 if you’re younger than 50 years old.
- It is dependent on how much you earn. It implements a phase-out range, which begins at $120,000. Once you earn $135,000, you cannot contribute to a Roth IRA.
- If you need to withdraw earnings before reaching 59.5 years old, you will face a 10% penalty unless the withdrawal is subject to an exception.
How to Maximize Your 401(k) and Roth IRA
It’s normal to feel overwhelmed when deciding between a 401(k) and Roth IRA, but here’s some good info: you can actually have both types of accounts! Check out these tips for maximizing your 401(k) and Roth IRA:
- Contribute to your 401(k) first to maximize employer contributions.
- When you max out your 401(k) limit, you can still invest in an Roth IRA to put more money away toward retirement.
- Another option is put the same amount your employer matches into your 401(k). Then, contribute more money to your Roth IRA since you can make penalty-free withdrawals from your Roth IRA contributions if needed. This can be a rainy-day fund in case of emergency.
- Look closely at Roth IRA fees to see how they’re impacting your total investment.
- Vary your conservative and aggressive investments to ensure your portfolio is as diverse as possible.
- Consider working with a financial advisor to ensure you make the best decisions.
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Do you prefer to save retirement money in a 401(k), a Roth IRA, or both? Answer with your choice below.