What’s the Difference Between a Roth IRA & a 401(k)? That is exactly what I will try to help you understand in this short post! In 5 minutes from now you will know all about it!
Your future matters
You may think retirement is a long way off but take it from someone who is already there. Time flies by quicker than you realize. What this means is that you should be making retirement decisions now, so you will be ready for that day when retirement hits you.
These decisions mean exploring your retirement savings options. Not all retirement saving plans are the same and the decision you make can either cost you money or help you build a nice nest egg.
To help you make the right decision, here is a comparison between the Roth IRA plan and the 401(k) savings plan. Keep reading to get all the important information you need to know so you can make an informed decision.
A Roth IRA vs. 401(k) overview
The biggest difference between these two retirement savings plans is how they are taxed. In a 401(k) you make your contributions prior to your being taxed. Then when the time comes for withdrawal, you will be taxed at your current tax level.
However, the Roth IRA is not taxed at retirement but contributions are not made pre-tax. In other words, you will pay some sort of tax on your contributions at some point in time.
You just have to work out which option will have you paying less tax. Your tax rate currently and at retirement will change but you can still get an idea of which way is the least taxed.
What is a 401(k)
This is a retirement savings plan that was named after the IRS 401(k) tax section. All this savings plan does for you is help you save money for retirement. You tell your employer how much you want to be taken out of your check every payday and it is done.
The money is deposited into your retirement savings plan for you. Here is the best part, your employer will match up to 6% of your salary so you get double the savings. Also, your employer’s contribution does not count towards your contribution limits.
That allows you to save even more money than you had anticipated.
The advantages of a 401(k) savings plan
- You can contribute more than ever- under 50 years of age you can contribute up to $20,500 a year. if you are over 50, you can add in an additional $6,500 ‘catch-up’ funds for a total of $27,000 per year in retirement savings
- You get help- your employer will match your contributions up to 6% of your salary per year
- Contributions lower your current taxable income- your taxable income decreases with each contribution so you pay less at tax time
- It is yours to keep- you do not lose this money if your employer goes bankrupt or you lose your job. You can roll it over into a Roth Ira if you want.
The disadvantages of a 401(k)
- Fewer mutual fund investment opportunities- your employer hires someone to make the investments and they choose which funds you can invest in.
- You will be taxed- it may not be right away but when you reach retirement age you will be taxed on the amount in your plan. This could get fairly high depending on your tax bracket.
- There are penalties- you must draw out a certain amount of money each year at age 72 or you pay a fee. Plus, if you withdraw money when you are 59 1/2 and younger, you will pay a penalty.
- You may have to wait to sign up- some employers have a waiting period before they allow you to sign up to their 401(k) plan.
What is a Roth IRA
The big difference between this savings plan and the 401(k) option is that your employer is not involved. There will be no matching funds from your boss. A Roth IRA is an individual retirement account and it is yours alone. You set it up for you.
Plus, you get more investment freedom. You get to choose which funds you want your money invested in. Since you are making contributions with post-tax money, you will not pay any taxes at retirement when you begin to pull your money out for your expenses.
Advantages of a Roth IRA
- No retirement tax fee to worry about- The money has already been taxed.
- More investment options- there is no employer administrator making your investment choices. You get to select from thousands of different opportunities.
- You have more flexibility- you can open a Roth account at any time and your employment situation does not affect your Roth account.
- No required withdrawal- you are allowed to keep your money in the account for as long as you want with no penalties
- You can save for your spouse- it is possible to open a Roth IRA account for your non-working spouse. You are saving for him or her as well as yourself.
Disadvantages of a Roth IRA
- Lower contribution ceiling- you are only allowed to contribute up to $6000 per year if you are under 50 years of age. $7000 if you are over 50.
- Income limitations- if you make too much money then you cannot open a Roth IRA. The benchmark is $144,000 per year if you are single and $214,000 if you are married. These are the 2022 rules.
- The 5-year rule- once you open your account, you cannot withdraw any money for 5 years. If you do, then you are subject to taxes and penalties.
Required Minimum Distributions
It may be your money but the government sets the rules on how you can use your money for retirement. This required minimum distribution or RMD is the lowest amount of money you can take out of your retirement plan.
Once you reach age 72 you must start taking money out of your account. This withdrawal is supposed to start by April 1 of the year following the year you turned 72. So you have some time to plan how much and how you will use the money each year.
If you do not withdraw the minimum yearly amount, your balance is subject to a 50% tax penalty. This will be on top of the tax you pay at retirement when you start using your 401(k) nest egg.
The good news is that there is no RMD requirement for this account. You can withdraw as little or as much as you want each year or you can leave the money in the account and give it as an inheritance to your children or grandchildren.
This does not mean that the money is penalty or tax-free. You must meet certain conditions to avoid those taxes and penalties. if your account is 5 years old or older and you meet the following criteria, you will avoid those taxes and penalties:
- you wait till age 60 to start withdrawing funds
- the money is withdrawn due to a permanent disability
- it is part of inheritance after you die
- used to buy, build or rebuild your first home (a $10,000 maximum may apply here)
Since you do not have to take an RMD, you can let the money remain and build it up for whatever purpose you may have. Also, if you do not meet those criteria, you may still be able to avoid the penalty but not the tax.
A quick comparison chart
This chart should help you understand the difference at a glance. it makes a side-by-side comparison so that you can see those differences clearly.
|Immediate tax breaks||Yes, contributions are deductible||NO|
|Withdrawals||Taxed as ordinary income||Not taxed|
|Contribution limits||under 50- $20,500
over 50- $27,500
|under 50- $6,000
over 50- $7,000
|Income limits||None||yes, you have to make under $144,000 as a single person or under $214,000 if you are married to open an account|
|Automatic payroll deduction||Yes||No|
|Minimum withdrawal age||59 1/2 penalties for early withdrawal||59 1/2 possible tax and penalties for early withdrawal|
|RMD||Yes, starts the following year after you turn 72||None|
|Average fees||can be high||can below|
|Investment choices||not that many||more than you thought|
|Maintained||By employer||By you|
Which is better the 401(k) or the Roth IRA?
This is a case where neither is better than the other. Instead, if you can afford it, you can do both and really maximize your retirement savings. That way you do not miss out on your employer matching benefits and can save on taxes until retirement.
It is possible to open up a Roth IRA and also make contributions to your employer’s 401(k) plan at the same time. Since the maximum contribution you can make is between $6 & 7,000 dollars for the IRA, this plan should work for you.
After all, you get to decide the amount of money that is deducted from your payroll check. Pick a comfortable percentage rate and then sit back and watch your retirement savings grow.
The only problem with this plan is if you make too much money each year and you cannot open a Roth IRA. Do some more research on this topic and see which plan or combination of plans will work for you.
Also, before you make the leap, talk to a retirement specialist who knows these plans inside and out. Get their expert advice first before making your decision. Knowing everything you can will help you when you reach retirement age.
Remember, retirement comes fairly quickly so it is best to make your plans now. That way you will be prepared when your career ends at age 65. Who knows, you may have saved enough to retire early.
I hope you found this post of a Roth IRA vs 401(k) to be helpful and that you now have a better understanding on the subject. Please share your own experience in the comment section below! Also, if you got any questions about this I would be more than happy to answer them below!
I wish you success!
Michael, founder of Gold Retired