Investing is key to preparing for your retirement. But knowing how to invest money and figuring out where to invest yours can be tricky. You could contribute to several types of accounts depending on your situation. Each may have its tax benefits, advantages, and disadvantages.
Two popular ways of saving for retirement include the Roth IRA (Individual Retirement Accounts) and a traditional 401(k). Deciding which to choose requires you to understand how each works. Take the following into account when making your choice between a Roth IRA vs. a 401(k).
A quick comparison of Roth IRA vs. 401(k)
Here’s a summary of some of the significant differences between Roth IRAs and traditional 401(k)s.
|Roth IRA||Traditional 401(k)|
|Tax break contributions||None||Contributions made pre-tax in most cases|
|Tax on withdrawals||None||Ordinary income tax|
|Mandatory withdrawal age||None||72 if you haven’t reached age 70 1/2 by Jan. 1, 2020|
|Early withdrawal penalties||Yes, 10% early distribution tax plus taxes on earnings in certain circumstances||Yes, 10% early distribution tax plus ordinary income tax|
|Loans||No||Possible depending on plan sponsor|
|Income limits||Yes, based on MAGI (modified adjusted gross income)||None|
|Contribution limit (for tax year 2022)||
+$1,000 (if age 50 or over)
+$6,500 (if age 50 or over)
|Contribution limit (for tax year 2023)||
+$1,000 (if age 50 or over)
+$6,500 (if age 50 or over)
Roth IRA: The basics of this tax-advantaged account
A Roth IRA, one of the many IRA types, is a tax-advantaged retirement account you open outside of your workplace. You can open this type of account at most brokerage firms, such as Vanguard or Fidelity, and also some banks and credit unions. The brokerage you choose will determine which investment options you have. Even so, brokerage firms almost always offer more investment options with an IRA than a 401(k) plan.
Roth accounts don’t give you a tax break today for contributing to the account. You can generally withdraw from a Roth IRA tax-free once you reach age 59 1/2 and you’ve held the account for at least five years or under certain other circumstances. This means any earnings your investments make in the account are never taxed if withdrawn correctly. This is essentially free money in your retirement savings.
On the other hand, traditional IRAs are tax-deferred accounts that allow you to contribute on a pre-tax basis if you meet the eligibility requirements. This enables you to get a lower tax bill today. However, your contributions and earnings will be subject to income tax when you withdraw them in retirement.
If you make withdrawals from a Roth IRA before age 59 1/2, you could face a 10% early withdrawal penalty. You may have to pay taxes on your earnings, as well. There are exceptions in specific cases.
Additionally, Roth IRAs don’t have RMDs (required minimum distributions) as traditional IRAs do. You can continue letting your money benefit from tax-free growth after age 72. Unfortunately, IRAs don’t allow loans against your balance as 401(k) plans might.
For tax year 2022, Roth IRA contributions are capped at $6,000 as long as you fall under the income limitations. If you’re age 50 or older, the total annual contribution limit increases to $7,000 due to the allowance for catch-up contributions. Those with a MAGI higher than the limits listed below may not be able to contribute directly to a Roth IRA or may be subject to a lower contribution limit.
|Married filing jointly or qualifying widow(er)||$204,000 or higher|
|Married filing separately and lived with your spouse at any time during the year||$0 or higher|
|Single, head of household, or married filing separately and you didn’t live with your spouse at any time during the year||$129,000 or higher|
If your MAGI exceeds these limits, you may be able to take advantage of the tax rules to fund what’s known as a backdoor Roth IRA. This isn’t an official retirement account type but it may allow high-income individuals to fund a Roth IRA. If you’re interested in learning more about this strategy, you should speak with a financial professional.
Roth IRA pros
- Backdoor Roth IRA option for those with high income
- Can choose where to open your account
- Higher annual contribution limit for those 50 and older
- More investment options
- No RMDs
- Tax-free withdrawals in retirement
Roth IRA cons
- Contribution limit tied to MAGI and tax filing status
- Early withdrawal penalty
- Lower contribution limits than 401(k)s
- May have difficulty choosing where to open an account and what to invest in
- May have to pay taxes on earnings in some cases
- No tax break today for making contributions
- No loan options
- No matching contributions
401(k): The basics
A 401(k) is a workplace retirement plan that you may contribute to when a company offers one. Unlike a Roth IRA, you cannot open these on your own — the availability of this type of retirement savings plan depends on your employer. In addition, your investment options may be limited as this account type typically allows you to choose from pre-selected investments offered by the plan.
Traditional 401(k) contributions may be made on a pre-tax basis. This means contributions reduce your taxable income. For tax year 2022, the 401(k) contribution limit is $20,500. For those 50 or older, the annual contribution limit increases to $27,000. Your workplace may also limit your contributions to a lower amount in rare circumstances.
Your company may also offer employer contributions as a benefit in addition to what you put in the plan. To earn a company match, you must normally contribute a particular amount of your own money. For instance, a plan may offer to match 3% of your salary if you contribute at least 3% to your 401(k) account. You may not get to keep an employer match immediately. Some plans require you to work for the company for a number of years before you fully vest, or own, the employer match contributions.
Money withdrawn from this account is subject to ordinary income taxes. And, if you withdraw money before age 59 1/2, you may have to pay a 10% early withdrawal penalty. Some exceptions could allow you to withdraw money earlier without a penalty.
Unlike a Roth IRA account, you must take RMDs from your 401(k)s starting at age 72. This forces you to withdraw a minimum amount from your 401(k) account each year. If you don’t make the required distribution, you face a 50% excise tax on the amount you should have withdrawn.
Each 401(k) plan is set up differently and provides its own options. That said, they must follow IRS rules. You may be able to take out a loan against your 401(k) balance if your employer offers this as part of their plan. Some 401(k) accounts offer Roth 401(k) options that enable you to contribute money on a post-tax basis and withdraw money tax-free in retirement.
- Contribute pre-tax money lowering taxable income today
- Higher contribution limits for those age 50 or older
- Higher contribution limits than Roth IRAs
- Loans may be available
- Matching contributions may be available
- Can’t open an account wherever you like
- Contributions may be limited for certain employees
- Early withdrawal penalty
- Investments options limited by the 401(k) plan
- Pay taxes on distributions
- RMDs start at age 72 (sometimes age 70 1/2)
How to pick between a Roth IRA vs. 401(k)
Deciding between a Roth IRA vs. 401(k) may seem difficult. Which investment account type you choose will depend heavily on your situation and your future expectations.
- First, see whether your workplace offers a 401(k) or other workplace retirement plan. If they don’t, your only option is to open a retirement account outside of work.
- Next, check to see whether your MAGI exceeds the income limits for contributing to a Roth IRA based on your filing status. If it does, you may not be able to contribute directly to a Roth IRA or as much as the usual limits allow. In this case, you may want to consider a 401(k) or backdoor Roth option.
Once you understand which account types you’re eligible for, you can look at your financial situation and expectations on a deeper level. Let’s walk through the factors you should consider.
Tax impacts and predictions
Part of choosing a Roth IRA or a traditional 401(k) has to do with your current and future expected tax situation.
If you believe your current tax rate is higher now than you may pay in retirement, it makes more sense to take a tax deduction for traditional 401(k) contributions now. Then, you pay taxes in retirement when you withdraw the money. For example, people in their highest earning years may end up in a lower tax bracket in retirement.
If you believe you will be in a higher tax bracket in the future, it makes more sense to contribute post-tax dollars to a Roth IRA. Then, you can withdraw the money tax-free in retirement. This is common for people early in their career who expect to earn more in the future, which would require paying more taxes on those dollars.
Roth IRAs are also popular among those who feel income tax rates as a whole may increase. Higher federal government spending and the growing national debt may cause this. Unfortunately, no one has a crystal ball and tax law changes regularly. Additionally, your income could change drastically in the future. As a result, there is no certainty as to which option ends up being right. You just have to make an educated guess.
Investment choices and costs
Roth IRAs typically give you more investment options than 401(k)s do but having more options doesn’t automatically mean the investments are better. Due to their size, many 401(k) plans at large employers offer a diversified set of extremely low-cost investments. Unfortunately, smaller 401(k) plans may have higher investment costs than investing on your own in a low-cost Roth IRA. That means your dollars would go further in a Roth IRA depending on the 401(k) your company offers.
Your employer may offer matching contributions in a 401(k). In this case, it usually makes sense to contribute enough money to earn the full match first before you invest in a different retirement account.
You could decide to use both
Thankfully, you don’t have to invest only in a 401(k) or Roth IRA. In many cases, you may contribute to both types of retirement accounts. Doing so could help diversify your tax benefits and offer more tax planning opportunities.
Your money isn’t stuck in a 401(k) forever
Most employers force you to keep your funds in a 401(k) until you leave the company. Once you leave the company, you may roll over your 401(k) to an IRA at the brokerage firm or financial institution of your choice. A rollover like this could allow you to unlock other investment options that may not have been available in your original 401(k) plan.
Can I have a 401(k) and a Roth IRA at the same time?
Yes, you can have both a 401(k) and a Roth IRA at the same time. However, there are income eligibility limitations for the Roth IRA, so you need to make sure you meet those requirements before opening the Roth IRA account.
Can you lose money in a Roth IRA?
Yes. Because a Roth IRA may contain investments (some are simply retirement savings accounts), there is the chance you will lose your principal. There is always a chance of losing money when you’re investing in the stock market.
However, it’s important to note that portfolio losses aren’t usually locked in until you actually sell your shares. In many cases, if you avoid selling your shares during a market crash, there’s a chance you will regain the value over time as the market recovers.
What kind of investments can I make within my 401(k)?
In general, your investments are limited to the choices provided by your plan sponsor. Many 401(k) plans include a mix of mutual funds, usually stock and bond funds, that you can use to create a portfolio with an asset allocation that meets your needs. You might also be able to invest in annuities and company stock.
The debate on investing in a Roth IRA vs. 401(k) comes down to your personal situation and your personal finance goals.
Roth IRAs don’t offer a tax break today but allow you to withdraw money tax-free in retirement. Alternatively, a traditional 401(k) enables you to make contributions pre-tax and effectively lower your taxable income today. Unfortunately, this comes at the cost of paying ordinary income taxes on all money withdrawn from a traditional 401(k) in your retirement.
If figuring out which account type is best for you is giving you a headache, consider consulting a financial advisor. They can take a look at your situation and help you explore which option is best for your circumstances. These experts may help you avoid costly retirement mistakes or unintended tax consequences you may not know about.
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