When deciding on retirement saving strategies, Roth IRAs and 401(k) plans may end up at the top of your list. But how does each plan work? What are the key differences? And why would you choose one plan over another, or is it best to have both? These are all valid questions that will help you select the best retirement plan for your needs.
Read earn to learn the answers to these questions and much more.
How Roth IRA Plans Work
You may have heard the term, IRA, on more than one occasion. And in case you weren’t aware, you should know that there are several variations of the IRA, including the Roth IRA.
Traditional IRAs are known for their tax benefits as contributions are pre-tax, which means they help offset your taxable income so you’ll pay less to Uncle Sam and keep more of your hard-earned money in your pocket. This is also good news as your earnings will grow tax-deferred until distributions begin at age 59 ½ (but no later than 70 ½). At that time, you’ll pay taxes on your distributions, and the liability will be determined by the tax bracket you fall in. And if you withdraw before this age, you will pay Uncle Sam federal income tax on the distribution amount plus a 10 percent penalty.
Roth IRAs don’t quite work that way. While you’ll make contributions in the same manner as you’d do if you had a traditional IRA, they’ll be on a post-tax basis. Consequently, you won’t incur tax savings right away, but you could save a fortune at retirement time when you begin taking distributions since they are non-taxable.
But why would anyone want to wait that long to incur cost-savings? If you think you’ll be a higher tax bracket at retirement, opting to make post-tax contributions to a Roth IRA could save you a fortune later on down the line.
Wondering how much you can contribute per year? Similar to traditional IRAs, annual contributions are limited to $6,000, but you can make catch-up contributions of $1,000 if you’re 50 years of age or over. However, there’s no minimum age to start taking distributions until the owner dies. But if you take an early distribution from earnings before you reach 59 ½ years of age, you’ll be subject to a 10 percent penalty. The good news is you can withdraw contributions at any time without incurring a penalty.
An important note: you can only contribute to a Roth IRA if your adjusted gross income does not exceed $124,000 ($196,000 if married filing jointly). But if your income is slightly higher, you may be able to make reduced contributions.
How 401(k) Plans Work
A 401(k) is a type of IRA, but it’s sponsored by an employer, which means you can’t just walk into a financial institution and open an account on your own. They are similar to traditional IRAs, but a major drawback is the limited number of asset options you may have as these are pre-determined by your plan administrator.
Per the IRS, individual contributions are capped at $19,500, annually, with catch-up contributions of $6,500. What makes 401(k) plans stand out is the ability to garner matching contributions from your employer if it’s something they offer. But if you choose not to participate, you’ll be leaving free money on the table.
To illustrate how this works, assume you earn $150,000 each year. You’re enrolled in a 401(k) plan, and your employer matches contributions of up to 4 percent of your gross earnings. This means you can earn up to $6,000 by making contributions of at least this amount per year.
Another major benefit is that you may be able to take out a loan if permitted by your plan administrator. While it’s not highly recommended unless you’re in dire financial straits, 401(k) loans are easy to get as there are no credit checks or lengthy applications. Even better, any interest paid on the loan is deposited right back into your account.
Withdrawals can be taken once you reach 59 ½ years of age, but you’re not obligated to do so until 70 ½. But if you decide to take a premature distribution, you’ll be subject to an early withdrawal penalty of 10 percent on top of ordinary income tax.
Side-by-Side Comparison of Roth IRAs and 401(k) Plans
|Retirement Plan||Annual Contribution Limits||Contribution Type||Withdrawals||Minimum Distributions||Penalties|
$1,000 (for catch-up contributions)
(and permitted after 70 ½)
|Non-Taxable||Not required until the owner passes away||10% penalty if withdrawn before 59 ½ (earnings only)|
$6,500 (for catch-up contributions)
|Pre-tax||Taxable||Must be taken by age 70 ½, but can start as early as 59 1/2||10% plus taxes for premature distributions|
Which Retirement Plan Is Best?
If your employer offers a match on your 401(k), it’s best to start by making enough contributions there to take advantage. But if there’s no incentive to beef up your 401(k) and you’re not impressed with the plan options, a Roth IRA could give you the flexibility you’re looking for.
But your investment adviser will probably recommend that you start with a traditional IRA first if you choose not to participate in your employer’s plan. Doing so will lower your taxable income and free up more cash to contribute to your nest egg. Plus, you’ll give compounding interest an even greater opportunity to work in your favor.
Is your income too high for a Roth IRA? If so, your only options would be a 401(k) and traditional IRA. In this case, you’d capitalize on the employer match and move on to the traditional IRA if you have more cash to spare.
The Bottom Line
Roth IRAs and 401(k) plans offer many perks if you’re looking to build your nest egg. But before deciding on a retirement strategy that best suits your needs, it’s a good idea to consult with a reputable financial advisor for additional guidance.