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ROTH IRA vs 401(k)
ROTH IRA vs 401(k), which is better?
When it comes to preparing for retirement, it’s best to start as early as possible. Because many people struggle to determine which retirement plan is right for them, planning for the future might be stressful. Working-class individuals want to ensure that they’re putting their contributions to their best use. However, it often is not as easy as making a quick decision.
Roth IRAs and 401(k)s are two well-known retirement plans that individuals consider when they’re deciding where to put their funds. Often times, a person’s employer offers 401(k) as part of their employee perks. This does not mean that individuals have to rely on this plan, though.
It’s in an individual’s best interest to examine the variety of investment options they have in terms of retirement planning. By educating oneself on the perks and setbacks of these retirement savings plans, it becomes much easier to make an informed decision and set a solid retirement strategy.
Read on for a comparison of ROTH IRA vs 401(k).
What is a ROTH IRA?
A Roth IRA is a type of retirement account where individuals can regularly contribute to the balance over time. In addition to adding funds to the account, the account holder can invest their contributions into other venues. This includes mutual funds, stocks, bonds, or other portfolio investments. These contributions and investments grow over the lifetime of the account. When the time comes for withdrawals, funds are usually tax-free if the account meets all the required conditions. With Roth IRA accounts, the account holder is in charge of the investments and contributions made. Because they own and operate the account, their employers are not involved with the funds or their dispersion. Account-holders manage Roth IRA accounts, though there are regulations they have to follow to avoid penalties.Benefits of ROTH IRA
Because Roth IRA accounts are built with pre-taxed money, the funds grow tax-free for as long as they remain in the account. In addition, when the time comes to withdraw funds, the withdrawn amount is tax-free as long as it meets the required conditions. For one, the account holder must have had the account for at least five years before making a withdrawal to avoid penalty charges.Tax Treatment of ROTH IRA
A Roth IRA account grows tax-free for the length of time the account is in operation. There are rules that the account holder has to meet to avoid incurring financial issues. Because the funds are pre-taxed, they won’t incur additional taxes when withdrawn. However, penalties can incur if the account holder needs to make a withdrawal before the account reaches its five-year mark. Investment earnings have slightly different rules than standard contributions as well. For funds that are the result of an investment, the account holder must leave the funds where they are until he or she reaches the age of 59.5. Failure to do so can earn the account holder a 10% penalty and additional income taxes on the funds they’re withdrawing.ROTH IRA Required Minimum Distribution
With Roth IRA accounts, the account holder does not need to take a required minimum distribution during his or her lifetime. If the account holder does not currently need the funds, he or she can leave the funds in the account. This way, they can continue allowing funds to grow for years or even decades with no taxes or penalties. Because of this, many account holders choose to leave their Roth IRA funds to their beneficiaries after their death. It’s important to note that beneficiaries receiving these funds as inheritance aren’t subject to the same freedoms as the account holder. Beneficiaries have to take a specific required minimum distribution, lest they face a 50% penalty or excise tax.What is a 401(k)?
Like Roth IRA accounts, a 401(k) is also a type of retirement plan. Unlike Roth IRAs, a 401(k) is an employer-sponsored account. To contribute to a 401(k) account, the account holder would designate a specific portion of each paycheck to deposit into the account. Keep in mind, this deposited portion relates to the paycheck’s gross amount. Because of this, taxes aren’t deducted for the paycheck portion at the time it’s deposited. The funds within the account will grow without taxation by the IRS as well.The Tax Benefit of a 401(k)
Having a 401(k) and making contributions to it are subject to tax breaks. For example, when an account holder contributes money to the account, they can claim the deposits on their income tax returns. This effectively results in tax deductions; it reduces their taxable income and saves them money. Because the funds aren’t taxed at the time they’re contributed or during the lifetime of the account, account holders have to pay taxes on their 401(k) accounts when they start making withdrawals during retirement. Distributions get taxed at the account holder’s then-current tax rate.Tax Treatment of a 401(k)
Because the contributions made to a 401(k) account are pre-tax dollars, they’re subject to taxation upon withdrawal. Typically, 401(k) distributions are taxed like ordinary income according to the tax bracket the account holder is in at the time of the withdrawal. Exceptions to this taxation apply to people who were born before 1936, or people who withdraw their distribution as a lump sum. In these cases, special tax treatments apply.401(k) Required Minimum Distribution
401(k) account holders have to take minimum distributions by the first of April during the year they turn 72, or the first year of retirement (whichever happens later). Required Minimum Distributions (RMD) refers to the sum that account holders have to withdraw from their account at the start of retirement or at the age of 72. Account-holders can make an estimate on their Required Minimum Distribution by dividing the balance of their 401(k) account as of the last day of the previous year by their life expectancy factor. This factor can be determined by consulting the IRS Uniform Lifetime Table.401(k) Employer Match
One benefit of having a 401(k) plan versus a Roth IRA is the fact that an account holder’s employer matches their contributions to the account. This applies up to a certain percentage of the account holder’s salary. Some employers match more than others, but the addition can be very beneficial. If the account holder contributes 20% of their paycheck, their employer might match 50% of it. This means that they’re paying into the account holder’s retirement fund. With the employer matching option, the sum matched by the account holder’s employer does not count toward the contribution limit. However, there is a cap on how much money can go into one’s 401(k) account each year. For example, an individual’s contributions cannot exceed their salary for the year. If the account holder does not work or earn any income for a year, they cannot contribute to the account.Comparing Plans
With the basics of both plans covered, it’s a good idea to compare and contrast features for ROTH IRA vs 401(k). This way, individuals can determine which plan fits their needs based on the benefits for retirement savers that each account type offers.Max Funding Annual Amount Comparison
Contribution limits differ from one individual retirement plan to another. For Roth IRA accounts, contribution limits are set at $6,000 per year as of 2020. In addition to having contribution limits, a Roth IRA account also has income limits set in place. Currently, the income limit for single account holders is $139,000 and for a couple of joint account holders $206,000. As an account holder’s income increases, their ability to contribute to a Roth IRA account phases out. Also, like with 401(k) plans, an individual cannot contribute more to their Roth IRA than their taxable compensation for the year. If an individual only makes $10,000 in a given year, they cannot contribute more than $10,000 to their Roth IRA. Those with no income will contribute $0 for the year. Contribution limits for 401(k) plans are a little looser. In late 2019, the employee contribution limit was increased to $19,500 from $19,000. When it comes to the combined employee and employer contribution limits, that maxes at $57,000 for a year. Account holders over 50 years old are eligible for an additional “catch-up” contribution of $6,000 per year. This equals out to a grand total limit of $63,000. In terms of income limitations, there aren’t exact numbers in place when it comes to 401(k) limits. Employees who own more than 5% interest in a business, or those who are in the top 20% of employee compensation are subject to more regulations for Highly Compensated Employees (HCE).Early Withdrawal Comparison
Roth IRA
There are no penalties associated with early withdrawal from Roth IRA accounts in relation to the age of the account holder. If the account is less than five years old, any income tax and a 10% penalty are applicable for withdrawals. If the account is greater than five years old, account holders are free from penalties on withdrawals in retirement. Individuals who meet certain criteria can avoid taxes and penalties if a withdrawal is necessary for the following:- The account holder has become permanently disabled.
- The account holder has died, and their beneficiary is making the withdrawal.
- The funds are to buy, build, or rebuild the account holder’s first home (though there is a lifetime limit of $10,000).
401 (k)
Qualified withdrawals from a 401(k) account differ from Roth IRA withdrawals. The account holder needs to be 59.5 years of age or older to withdraw money without incurring the 10% penalty. Also, unlike the Roth IRA funds, 401(k) funds are taxable. In addition to paying a 10% penalty for early withdrawal, the withdrawn funds are also going to be taxed. In some circumstances, like those of economic hardship, early withdrawals from a 401(k) account are permitted. When the funds are needed for economic hardship, college tuition, childbirth or adoption, or a down payment on a first home, the penalty may be waived. Despite waiving the penalty, the funds are still subject to taxation. To qualify for an economic hardship need, the account holder’s situation has to meet the following criteria:- The withdrawal must be made as a result of immediate and severe financial need.
- The withdrawal must be within the limits of the funds necessary to satisfy the sudden financial need.
