Roth IRA vs. 401(k): Complete Guide to A Better Retirement

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If you’re starting to save for retirement, you’ve probably already faced the question: Roth IRA, or 401(k)?

Roth IRAs and 401(k)s are both popular retirement specific savings accounts with tax advantages and opportunities for growth. Although they’re similar on the surface, there are a few key differences between these two types of accounts, and there are definitely pros and cons to each.

In a perfect world, we would all be able to invest in both a Roth IRA and a 401(k) account. Unfortunately, not everyone has the resources for that – especially if you’re just starting to build up your retirement savings.

With that in mind, here’s everything you need to know about these two retirement account options, so you can make the best choice to maximize your savings.

Before we get into the differences between a 401(k) and a Roth IRA savings account, let’s go over the basics of each of them individually.

401(k) overview

A 401(k) is a common retirement savings plan sponsored by your employer. It lets you invest a small amount of your pay (either a percentage, or a set dollar amount) each month into retirement savings. That money can be invested into mutual funds to grow your savings.

And that small investment isn’t coming directly out of your monthly paycheck – it’s your pre-tax income, meaning you aren’t taxed on what you invest in your retirement right now. You don’t need to pay taxes on that money until you withdraw it for retirement.

A lot of companies offer what’s called an employer-matched 401(k) plan. That means that whatever you invest into your 401(k) each month will be matched by your employer. Basically, double the savings at no extra cost to you. (However, this is usually limited to a certain percentage of your salary.)

Even though your 401(k) account is sponsored by your employer, that money is all yours. When you leave your job, or the company closes, your 401(k) funds stay with you.

I should also note that some employers, especially tax-exempt and government organizations, will offer plans similar to a 401(k), such as a 403(b) or a 457(b). For you (the employee) those plans function just like a 401(k).

The good:

Employer match plans: An employer-matched 401(k) plan is essentially free money on top of normal investment growth.

High contribution limit: You can invest up to $19,000 every year in your 401(k). Over the age of 50, that contribution limit raises to $25,000 per year.

Tax deferment: Taxes on your 401(k) investments are deferred until you need to use them for retirement. That means less of your annual income is taxed every year.

No income limit: No matter what your income level is, you can invest in your employer’s 401(k) plan.

The not-so-good:

Must be employer sponsored: You can’t open a 401(k) retirement account on your own. That means self-employed people like freelancers don’t have access.

Fewer investment options: It’s up to a third party, hired by your employer, to decide which mutual funds you can invest your 401(k) funds into.

Waiting period: A lot of companies only open 401(k)s for their employees who have been working for a year or longer.

Roth IRA overview

A Roth IRA is an individual retirement account. You can open your account on your own, without an employer, and it’s up to you to manage it.

Unlike 401(k)s, Roth IRA accounts are not tax-deferred. You invest your income that has already been taxed – it may feel like a bigger investment at the time, but it means that once you reach retirement age (59 ½), all the money in your account is yours to use, tax free.

With a Roth IRA account, you decide how you want to invest your money to let it grow. You can invest it into any mutual funds you choose. Remember, since your contributions are already taxed, your returns on investments won’t be – that means potential for better, faster growth.

While you can’t access your investment earnings from your Roth IRA account until you reach retirement, you can get your contributions back at any time. That isn’t recommended, of course, but it’s nice to know that your money is still accessible in case of an emergency.

The good:

Individually established: You don’t need an employer to sponsor your Roth IRA account. It’s up to you when you want to start saving, how much you invest, and which mutual funds you invest in.

Tax-free growth potential: As your retirement account grows, your investment earnings won’t be taxed, which means a higher potential for growth.

No limits on distributions: You don’t have to withdraw your money at any time during retirement. It can stay in your Roth IRA account for your entire life, until you need it.

Spousal IRA: If you are married but don’t work, your spouse can open up a Roth IRA account for you and invest their income into both accounts.

The not-so-good

Low contribution limits: Your investment is limited to $6,000 each year for your Roth IRA account, or $7,000 if you’re over 50.

No employer match: Because Roth IRAs are managed by individuals, there’s no opportunity for employer contributions.

Income limits: There are some income limits to contribute the full amount to your Roth IRA each year. Your annual gross income has to be lower than $122,000 for an individual, or $193,000 for a married couple who files separately to contribute the full $6,000. If you make more than $137,000 in a year, you aren’t qualified for a Roth IRA account.

401(k) vs. Roth IRA: How do they compare?

Now that you’ve had an overview of both of these retirement account options, let’s see how they stack up against each other.

I’ve put together a few of the most important features of a retirement savings plan, so you can see how 401(k) and Roth IRA compare when it comes down to the details.

1. Accessibility

The very first hurdle we all face when we start saving for retirement is accessibility. Who can open a retirement savings account, and what kind of resources do you need?

401(k)

For a 401(k)plan, you have to be employed by a company who offers employer-sponsored 401(k). That means you don’t have access if you’re unemployed or self-employed. With most companies, you’ll also have to wait for a certain amount of time before you qualify for the savings plan.

However, once your employer sets up your 401(k), you’re good to go. You don’t need to have a certain amount to invest at the start, and there are no income limits for investment. In short, anyone who is offered a 401(k) by their employer qualifies to start saving.

Roth IRA

Roth IRAaccounts are very different when it comes to accessibility. You don’t have to be traditionally employed to qualify – but you do need to have some form of taxable income. Freelance income, wages, tips, and bonuses all count. You can also have your spouse set up a Roth IRA account for you if you don’t personally earn income.

On the other hand, there are limits to who can open a Roth IRA account. If you are in a higher income bracket, you won’t qualify.

It’s also important to remember that, with no employer contributions, you’ll have to be earning enough that you can set some money aside to contribute to your account yourself.

2. Contributions

Once your savings account is set up, whether it’s a 401(k) or a Roth IRA, the next thing you’ll have to consider is how much you’re actually going to contribute. After all, if you’re not putting any money into your retirement account, you’re not actually saving!

Here’s how these two options compare when it comes to contributions:

401(k)

Your contributions into your 401(k) are limited to $19,000 each year, or $25,000 if you’re over 50. But here’s the catch: that’s just your contributions.

Remember, most 401(k) plans are employer-matched. So, if you’re contributing $19,000 in one year, your employer could potentially matching that. The true limit to the contributions is around $56,000 each year (between both you and your employer).

Before you get too excited, you should know that employers usually put limits on that. In most cases, your employer will match 50% of your contributions, up to 6% of your salary. They also might utilize a vesting period, or a period of time in which their contributions aren’t accessible to you. In other words, if you leave the company before the vesting period is up, you’ll take your 401(k) contributions with you, but not theirs.

To sum it up: your contribution limits each year will largely depend on your employer’s policies.

Roth IRA

The contribution limits for Roth IRA accounts are a lot simpler, and also a lot lower. You’re limited to $6,000 every year, or $7,000 if you’re over 50. Additional limits might also apply if you earn more than $122,000 a year.

Remember, that’s all your own money – so there are no limits on what you can access if your employment situation changes.

3. Investment

No matter how much you’re contributing to your 401(k) or Roth IRA account, the way you turn that money into a decent nest egg for retirement is by investing it into mutual funds. The idea is the same for both types of accounts, but there are some slight differences in how you invest.

401(k)

Your employer will work with a third-party investment company to set up your 401(k) account for you. Once you start saving, you can decide how much you want to invest each month/year, and which funds you want to invest in.

However, your choices will be limited to whatever the third-party administrator decides. If you’re someone who doesn’t know much about investments, that can be an advantage – they’ll provide you with a list of dependable funds that will safely grow your investments, so you don’t have to do the research yourself. Having limited choices isn’t always a bad thing, especially when it comes to investing.

Roth IRA

How you invest through your Roth IRA account will depend on which investment company you set it up with.

If you want a little support choosing the right funds to invest in, you can always invest with a robo-advisor, or an investment firm that provides advice and automated options that will take the work out of your hands.

It’s also important to note that while ETFs and mutual funds are considered the safest choice for a retirement account, you can invest your IRA contributions however you choose: in traditional stocks, bonds, or REITS. It’s a little riskier, but if you’re a skilled investor, you have the opportunity to grow your investments much faster.

4. Tax Breaks

One area where these accounts really differ is taxes. Here’s how your 401(k) contributions will be taxed, compared to a Roth IRA.

401(k)

401(k) retirement plans come with tax deferment. That means that everything you contribute to your account won’t be taxed until you eventually withdraw it. As a short-term advantage, this is awesome.

Think of it this way: if you make $45,000 in one year, and invest $5,000 into your 401(k), you’re only being taxed on $40,000. The savings you collect over the years should be worth it when you eventually pay taxes on your investment.

Roth IRA

The money you contribute to your Roth IRA account is your already taxed income. Once it’s invested, it won’t be taxed. In the short term, that might be a drawback: it won’t help you to get a better tax refund at the end of the year.

On the other hand, your investment will grow tax-free in your account. And once you reach retirement age, whatever you withdraw from your account is yours to spend.

401(k) vs. Roth IRA: Which is better?

So, which retirement account should you choose?

Obviously, there are pros and cons to each kind of investment account. Neither is really “better” or “worse” than the other. That said, there might be a better option for you, at this stage in your life.

Here are a few tips to help you make your decision:

1. Consider what you have access to

Remember, there are different limitations to who can access a 401(k) or a Roth IRA. If you’re not currently employed by a company that offers a 401(k) savings plan, I wouldn’t hesitate to open up a Roth IRA account. The sooner you start saving for retirement, the better – and it won’t limit you from accessing a 401(k) in the future.

2. Consider your time & resource limits

Focus on ETFs and Mutual funds in broad markets or industries for safety and security.

3. Your goal should be both

Most financial experts advice opening both a 401(k) and a Roth IRA account if you really want to maximize your retirement savings. You’ll get the tax benefits of the 401(k), plus the investment opportunities of the Roth IRA – not to mention all the other benefits of each.

So, don’t stress too much about choosing one or the other right now. If you only have the resources to open one account, start with whatever is most accessible for you at this stage in your life, and plan to open the other in the future.

Additionally, it always helps to discuss your options with a financial expert. They’ll help you make the best decision for your situation.

The bottom line: Start saving, however you can

Both 401(k) and Roth IRA retirement accounts are awesome ways to invest in your future. Even though they each have their individual advantages and disadvantages, what matters most is that you’re saving up for a better retirement.

The sooner you start saving, the better. So, whichever retirement plan you choose, commit to it! Start saving early, contribute to your account regularly, and watch your savings grow.

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