401k vs Roth IRA: What's the better Option?
There really can't be a winner when comparing 401k vs Roth IRA, as both have their set of pros and cons. Even when you consider the unique feature of the self-directed 401k plan, it cannot be considered a retirement solution that can fit everyone.
401k Vs Roth IRA
A better understanding of these two retirement plans can be gained when we compare their main features. The Roth 401k is a very similar account to the traditional 401k but takes the tax treatment of a Roth IRA. Contributions come out of your paycheck after taxes, but retirement distributions are tax-free. That means you avoid paying taxes on investment growth. Let’s look at each of them more closely to see which one is the better option for you.
What Is a 401k Plan?
Named after section 401k of the Internal Revenue Code, a 401k is an employer-sponsored retirement plan. To contribute to a 401k, you designate a portion of each paycheck by diverting it to a plan. These contributions occur before income taxes are deducted from your paycheck. Investment options between different 401k plans can vary greatly, depending on the plan provider. However, no matter which fund (or funds) you choose, investment earnings realized within the plan are not taxed by the Internal Revenue Service (IRS).
Investment gains you make within your 401k are never taxed by the IRS.
You get a tax exemption when you contribute to a 401k. That is because you can deduct your contributions when you file your tax return. This reduces your taxable income, saving you money. You will pay taxes after reaching retirement age and begin withdrawing from the plan. These distributions, as they are known, are subject to income tax at your current tax rate. If you think your income will be higher when you retire, you can plan ahead, as all income from your distributions will be subject to tax.
If you have a 401k, you have to start taking required minimum distributions (RMDS) before April 1 of the year following the year you turn 72 or the year of retirement, whichever is later. Here is a quick look at the pros and cons of 401k vs Roth IRA.
Pros
Employer contribution
Higher contribution limits
Maintained by employer
Cons
Fewer investment options
Minimum required distributions
Higher rates
What Is a Roth IRA?
In contrast to 401k, after-tax money is used to finance a Roth IRA. As a result, no income taxes are applied to withdrawals during retirement while in the account, investment earnings are not taxable.
You would establish a Roth IRA directly with your chosen investment company, which means that your employer is not part of the process as in the case of the 401k.
You would set up the account and monitor it along with the investment company. In addition, the options that you have to invest in are not restricted only by what this particular provider may offer. Therefore, you have more freedom to invest with a Roth IRA than you do with a 401k plan. The fees to maintain a Roth IRA, though, is higher than that of the 401k plan. Here is a look at the pros and cons.
Pros
Tax free withdrawals in retirement
More options for investing
No minimum distribution throughout your life
Cons
Limits of contribution are lower
No match contribution with your employer
Your income can dictate whether you can contribute or not
The Roth IRA, in most cases, maybe the ideal option when you think about choosing between 401k vs Roth IRA. One of the reasons is that it offers more flexibility as an investment vehicle with more benefits as it relates to higher tax. This is especially true if you will fall into the higher tax bracket later in your life. If you have a high income, however, your employer could offer a match for your 401k.
If you can deal with it, a great strategy is to have both the Roth IRA and the 401k at the same time.
Use the limit allowed to invest in your 401k and then fund a specific amount that the contribution limit allows. The funds remaining after that can be placed in the 401k plan. While everyone has a different financial situation, if you can afford it, this strategy is well worth it.
However, make sure you do your research prior to make any decision like this. If you are not sure, it is best to speak to a reputable financial planner. Ask pertinent questions to get the help you need so you can make the appropriate decision as it relates to your particular situation.
Roth or Traditional?
Roth or Traditional does not have a great effect on your investment unless you max out or have different tax rates now versus retirement. You can change other things. For example, you can rollover a Roth 401k to a Roth IRA, tax-free. And the Roth IRA will act as if it were directly contributed. You have to check with your employer, what their rules are. It can be allowed at any time or only in separation employment (when you leave the job).
If you make the most of your Roth accounts, then you will perform better than traditional accounts at the same nominal contribution. This is because they are tax-free, while your returns in the other accounts will have to pay taxes. However, it doesn't matter until the limits are reached. Until then, you could only invest the traditional tax savings, as well as the money you could invest in a Roth account. Therefore, it would make sense that you would:
Get the employer, to contribute to the entire 401k plan
The maximum of your Roth IRA contribution (possibly as a backdoor procedure)
All the money that you have stopped investing, put it into your 401k.
If you can max that much, then that is great. Do that for forty years so that your retirement will be as financially secure as can be. If you cannot max them, the most important is going the employer route because that is free money. Note that you can also roll over your Roth 401k to a Roth IRA at some point in time. Then you can withdraw your contributions from the Roth IRA without penalty or additional tax.
For those who make more money, a Roth IRA would make more sense once they retire, but if they are not at retirement age yet, it won’t have that effect. This is because it is ideal to pay a lower percentage of your income before contributing (as in a Roth IRA) than paying a higher percentage of tax on withdrawals (as in a traditional IRA).
Recap of Main Features
Let us now look at the comparison of main features based on important aspects:
Contribution Limits:
The contribution limit per year for 401k for 2011 was $16,500 and have been raised to $17,000 for 2012. For Roth IRA, individuals can contribute the amount of their taxable income or $5,000, which is less.
Contributions to 401k can be made regardless of the amount of income, while you can only contribute to this fund if your income does not exceed a certain amount based on your marital status.
Tax:
401k contributions are tax-free as they are deducted from income before tax is calculated, while Roth IRA contributions are after-tax.
However, upon maturity, you do not have to pay tax on withdrawals from your account, while 401k withdrawals are taxable.
Participation:
In 401k plans, the employer can also contribute, and match the amount contributed by the employee, or a percentage of it.
In Roth IRA, the individual is the sole contributor.
Investment choice:
In 401k, the individual does not have many options, and investment options are limited to the plan chosen by the employer.
However, in Roth IRA, the individual can, not only select the custodian, but also the various investment options that are offered.
Withdrawals:
You can withdraw from your 401k account only when you are 59½ years old. Any withdrawal before this date will attract a fine. However, contributions made to the Roth IRA can be withdrawn at any time. You can also keep your money in the 401k account until the age of 70½, after which it is mandatory to withdraw, whereas the Roth IRA has no mandatory withdrawals.
The Ideal Option
There are several advantages based on individual requirements and needs. The feature comparison above highlights the pros and cons of each plan.
For example, you could earn a lot if you opt for a 401k plan, where you can also get a contribution from your employer.
If taxes were the only consideration, both the 401k and Roth IRA plans offer their own benefits and will solely depend on what you require. If you don’t mind managing a tax burden while contributing and be able to withdraw from your plan while enjoying the freedom of taxes, then the Roth IRA option is for you. However, if you are concerned about future taxation, then the 401k option is best.
For many people, the Roth IRA has more benefits for those thinking of having access to different investment options.
However, you have to be verse on finance and economics to be successful. Your personal requirements will play an essential role in choosing the option that best suits you.
Conclusion
The differences between Roth 401k versus Regular or Traditional 401k are few. To reiterate, most importantly, Roth account contributions are after-tax and retirement withdrawals are tax-free.
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