Roth IRA Vs. 401(k): Which Is A Better Investment?

Key Takeaways


No matter where you are in your career, it is never too early to start saving for retirement. There are numerous options available that can ensure you have a steady income later in life. Perhaps two of the most well known are a Roth IRA and a 401(k), but you may be wondering how exactly they are different.

When considering a Roth IRA vs 401(k) there are several factors to keep in mind, and quite frankly you may find you want to open both types of retirement account. The important thing to remember is to do your research before getting started with either account (or both). Keep reading to learn more about how a Roth IRA or 401(k) can help you plan for your financial future.

What Is A 401(k)?

A 401(k) is a retirement savings account sponsored by an employer. These accounts allow users to add a certain amount of their pre-taxed income into the account directly from their paychecks. You will have a few options for investing the funds inside your 401(k), depending on your account type. More often than not, 401(k) accounts allow you to choose between different mutual funds, which invest in stocks, bonds, and money market investments.

There are limits to the amount you can add annually to a 401(k), depending on your age. If you are under 50, the annual limit is $19,500, for those 50 and older the limit is $26,000. You are not allowed to access the funds (without penalty) until right before you turn 60. There are also required minimum distributions that must be made starting the year you turn 72, or the year you retire. Your employer should provide information on these specifics if you are allowed to open an account.


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difference between ira and 401k

Employer Match 401(k)

The reason 401(k) accounts are so attractive to many users is that in some cases employers will match the contributions you make to the account. Many individuals consider this to be “free money” that helps bolster your retirement savings at a faster rate. An employer will typically match a certain percentage of your contributions, with a limit depending on your salary.

Depending on your company, you may have to be employed for a year before being offered a 401(k) while some allow employees to get signed up right away. However, you should be able to find out right away whether or not matching is provided at your company. This information can help steer your retirement account decisions, particularly when considering a Roth IRA vs 401(k).

401(k) Tax Break

A 401(k) pulls directly from your pre-taxed income on your paycheck. What this means for you is that contributing directly reduces your taxable income, while also setting aside funds to invest. This saves you money on taxes the moment you start contributing. It is worth noting that taxes will be applied once you start to make withdrawals from the account during retirement. These funds are subject to your income tax rate at the time of the withdrawal. This typically is not something to worry about, unless you believe your income will be higher in retirement.

Benefits Of A 401(k)

There are quite a few advantages of opening a 401(k) you should be familiar with. Read these to learn more:

  • Tax Breaks: The contributions pull from your pre-taxed income, this lowers your taxable income for the year. Later on, this could also mean you pay less income tax on those funds depending on how much money you make in retirement.

  • Employer Match: This is arguably the most attractive reason for opening a 401(k). If your employer matches up to a certain amount, you can essentially double your contributions for that year.

  • No Minimum Income: There is not a salary-defined limit on who is eligible for a 401(k). Meaning, you don’t have to meet a designated income level at your job to be eligible.

  • Contribution Limit: 401(k) accounts have an annual contribution limit of $19,000 (if you are under the age of 50). This is a relatively high amount, particularly because it does not count employer contributions towards the limit.

Disadvantages Of A 401(k)

With any form of financial planning, there are some cons to consider before opening an account. Read these potential hurdles to learn more:

  • Possible Waiting Period: Some companies will require you to work there for a year before giving you the option to open up a 401(k). This can seem stressful depending on your retirement planning situation.

  • Required Minimum Distributions: An interesting element about 401(k) accounts is that right after you turn 70, you are required to withdraw a certain amount per year. If not, you will pay penalties — just as you would for withdrawing your funds early.

  • Fewer Investment Options: You may find you don’t have many mutual funds to choose from when investing your 401(k). This lack of variety can be discouraging for some, although it all depends on where your account is managed.

What Is A Roth IRA?

A Roth IRA (individual retirement arrangement) is a retirement savings account set up directly by an individual with an investment firm. The fees associated with a Roth IRA vary depending on the firm you choose to work with. These accounts are a popular arrangement for individuals who decide against a 401(k) or are not eligible through their employer.

Contributions made to Roth IRA accounts are from your taxed income, however future withdrawals are therefore not taxed. Additionally, any gains made within the account are exempt from income taxes. Roth IRAs can have lower annual limits than 401(k)s, but they provide more freedom when choosing an investment type.

Roth IRA Contribution & Income Limits

Roth IRAs have annual contribution limits depending on your age and income level. The annual limit is $6,000 for individuals under the age of 50 and $7,000 for those 50 and older. Although, these limits only apply if your individual income is less than $124,000, or $196,000 if you are married and filing taxes jointly. For individuals who make between $124,000 and $139,000 or married couples making between $196,000 and $206,000 — the maximum allowed contribution is lowered. Those who make more annual income, are not eligible to open a Roth IRA.

Withdrawing Your Roth IRA

Roth IRA account holders can withdraw their contributions at any point in time, without penalty. Although it is important to discern between contributions and earnings. The amount you contribute can be taken out of the account, whenever you need to. However, any investment earnings taken out of the account before retirement age are subject to income taxes and a potential 10 percent penalty. There are exceptions made in the event of a permanent disability, death or the purchase of a house. If you are concerned about the penalties, be sure to research and ask your account manager before accessing the funds.

Benefits Of A Roth IRA

A Roth IRA can be highly beneficial to those who use these accounts correctly. Review the following advantages for more information:

  • Separate from Employers: If you are self-employed, or you are not yet eligible for your employer’s 401(k), a Roth IRA can be a great option. These accounts are set up and managed directly by you, offering a higher degree of control for those eager to start planning for retirement.

  • Tax-Free Earnings: Any income gains made within your Roth IRA are not subject to income taxes in the same way contributions are. You also will not pay any taxes on this money at the time of retirement.

  • No Required Minimum Distributions: This particularly interesting aspect to 401(k) accounts does not apply to Roth IRAs. Meaning, you will not be penalized for leaving your funds in the account after reaching retirement age (as long as you keep the account open for at least five years).

  • Spousal IRA: Both married partners can have a Roth IRA, regardless of employment status. For example, if only one spouse is working they can open a Roth IRA and contribute for both partners.

Disadvantages Of A Roth IRA

Again, there are always considerations to make when planning for your financial future. These are some of the common disadvantages of opening a Roth IRA:

  • Contribution Limit: The thing most individuals dislike about Roth IRA accounts are the relatively small annual income limits. When compared to the limits of a 401(k), $6,000 annually may not seem like much.

  • Maximum Income: There is a cap on the amount of income you can make to contribute to a Roth IRA. This can prevent individuals who make over a certain amount from opening a Roth IRA account, though they could still look into a traditional IRA.

roth-vs-traditional

Roth IRA Vs. 401(k): What’s The Difference?

When looking at a Roth IRA vs 401(k) it can be easy to get lost, after all the purpose of both accounts is the same: to help you prepare financially for retirement. Luckily, the differences are not as complicated as they may seem. Moreover, they can help you determine which account is best for you. Read through the following differences between a 401(k) and a Roth IRA:

  • Eligibility: A 401(k) only becomes available through your employer, while a Roth IRA can be opened at any time (regardless of employment status). Additionally, there are no income caps on a 401(k) like those that exist with a Roth IRA.

  • Taxes: The biggest difference between the two is how they are taxed. Contributions to a 401(k) are from your pre-taxed income, with taxes taken out at the point of withdrawal. With a Roth IRA, contributions are from your taxed income and are not taxed later on. A Roth IRA also does not apply taxes to any gains made within the investment account.

  • Contribution Limits: In general, 401(k) accounts have much higher contribution limits annually. Additionally, employer contributions are not considered in the maximum contributions. Roth IRA’s, on the other hand, have much lower annual contribution limits.

  • Employer Contributions: Depending on your employer, you may be eligible for 401(k) matching. Employers will match up to a certain percentage of your annual contributions, helping to grow your savings more quickly. Roth IRAs, because they are not set up by an employer, have no comparable benefit.

  • Required Minimum Distributions: Required minimum distributions say that you must withdraw a certain amount from the account after reaching retirement age or pay fees. These only apply to 401(k) accounts, and not Roth IRAs.

  • Investment Menu: Roth IRA’s are known to provide significantly more freedom when it comes to choosing how to invest. 401(k) options will all depend on the third-party administrator that your employer chooses to work with, and will typically be limited to a few different mutual funds.

  • Penalties: If you take money out of either a 401(k) or a Roth IRA before turning 59 ½ you will pay penalties. The only exception is if you withdraw your contributions (and not any investment gains) from your Roth IRA you will not be subject to penalties.

Roth IRA Vs. 401(k): Which Is Best For You?

The fastest way to determine whether a Roth IRA or 401(k) is better for you is to look at whether or not your employer matches. If your employer is willing to match your contributions up to a certain amount, it can be a great option to open a 401(k). Any matching contributions will bolster your retirement savings and allow you to grow those funds. If your workplace does not offer to match, a Roth IRA may provide the freedom to choose from a wider range of investment types. This freedom could allow you to grow your funds at a potentially faster rate. However, always check in with your financial situation and mind due diligence before choosing the right account to start with.

Can You Have a Roth IRA & A 401(k) At The Same Time?

You can have a Roth IRA and a 401(k) at the same time this can be a great way to save for retirement if you have the capital to contribute to both simultaneously. Many individuals get so focused on choosing a Roth IRA vs 401(k) they don’t realize you can have both accounts (assuming you do not exceed the income limits for a Roth IRA). If you have the resources to contribute to both, the bigger question should be, which account do you open first?

How To Invest In Both Roth IRA & 401(k)

When managed properly, having both a Roth IRA and 401(k) can be an excellent way to prepare for retirement. Get started by learning more about your 401(k) eligibility at work — do you have to wait a year to open an account? Does your employer match, and how much? Which mutual funds are available to you? If you do receive employer contributions, many financial planners might tell you to start by opening and contributing to this account. After you have a 401(k) you can set up and contribute to a Roth IRA at the same time.

Summary

No matter how close or far away retirement may seem, planning for your future finances can be intimidating. A great place to start is by learning about which options are available to you. Reach out to your HR department to learn more about the 401(k) plans offered at your workplace. Then try comparing your income to the limits of a Roth IRA. These steps should tell you which options you are eligible for. From there, weigh the advantages and disadvantages to decide between a Roth IRA vs 401(k). As you learn more about each option, consider the possibility of utilizing both, and maximizing your retirement savings.

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Real Estate Investing Strategies
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