Personal financial planning has changed over time as more options for saving for retirement have become available to individuals. If you compare a 401(k) vs Roth IRA, is one better than the other?
Can you have both? There are a lot of choices when it comes to saving for the future. Let’s take a look at the Roth IRA and the 401(k).
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What is a 401(k)?
It is an employer-sponsored plan that allows you to save for retirement. After you have worked for an employer for a designated amount of time, the option to contribute to a 401(k) plan is usually offered as a benefit.
401(k) monies are taken directly from your paycheck before your income is taxed. The money deposited into a 401(k) is taxed at the time of withdrawal.
A big benefit to most 401(k) plans is the employer will often match a certain percentage of the money contributed by the employee. The matched portion is free money.
Contributing enough to your 401(K) to get the match from your employer should be a priority for your savings plan.
You can contribute by law, at this time up to $18,500 per year and $24,500 if you are over the age of 50. 401(k) plans offer the following benefits:
– Employer match
– Tax deferred savings
– Lowers your taxable income
– Contributions can be made through a payroll deduction
401(k)s are a great way to save for retirement. If you start early and save consistently, you will have a nice nest egg by the time you are ready to retire.
Now, that brings us to the Roth IRA.
What Is A Roth IRA?
A Roth IRA is a savings vehicle that can be opened at many financial institutions. Some accounts have no minimum opening balance so virtually anyone can open one.
The biggest difference between a Roth IRA and a 401(k) is a Roth IRA is funded with after-tax dollars. Roth IRAs grow tax-free meaning no taxes are due on this money when it is withdrawn at retirement.
There are income limits for being able to contribute to a Roth IRA. If you are married and file a joint tax return, your household income has to be less than $194,000.
If you file a tax return as single head of household, or married filing jointly, your income limit is $132,000.
Benefits of a Roth IRA are:
-Easy access to the money
-Less ageist withdrawal rules
-IRA money is tax-free to beneficiaries
-Almost anyone can open one
-A 401(k) is done through an employer. If you are not employed or your employer does not offer a 401(k), saving money with a 401(k) will not be an option for you.
-A 401(k) is funded with pretax dollars
-You can contribute up to $18,500 annually to a 401(k) plan ($24,500 if you are over 50)
-A Roth IRA can be opened by anyone that has not surpassed the income limits
-A Roth IRA is funded with after tax dollars and grows tax-free
-You can contribute$5,500 annually to a Roth IRA ($6,500 if you are over 50)
ROI and Taxes
For many people, how they save is about what is going to give them the best return on their investment. I used to think that money growing tax-free in a Roth IRA was the way to go, and it is a great option.
A return on investment also takes into account what you pay in income tax each year. You have to look at every penny that makes up your income and where it is going.
Contributing to a 401(k) will keep your taxable income down, possibly putting you in a lower tax bracket. If you can get your taxable household income below $75,900, your tax bracket will go from 25% down to 15%.
The difference in paying 25% and 15% can be significant, allowing you to keep more of income in your bank account.
If you are in a lower tax bracket and your money has several years to grow, the Roth IRA may be the better option for you.
With all the growth being tax-free, paying the taxes upfront, allowing the money to grow for many years and being able to withdraw the money tax-free would be a good alternative as well.
With savings, it most often will come down to money. At the end of the day, which one of these accounts will keep the most money in your pocket?
If you are in a 25% tax bracket now and expect to be in a 15% tax bracket when you start taking your retirement income, the 401(k) is a good choice.
You will pay less in taxes at the time you withdraw the money. It is also possible if you contribute enough to your 401(k) your current tax bracket could drop to 15%.
If you opt to put the money in a Roth IRA, you may pay the higher tax percentage now and pay nothing at the time of withdrawal.
So, do you want to pay the taxes now or later on your money? Both of these savings vehicles are great ways to save money for the future.
For me, I have chosen to max out my 401(k) and the Roth IRA will come later. The reason…I need as many tax breaks as I can get.
Most of the calculators I have used to compare a Roth IRA and the 401(k) show the 401(k) providing a little bit more money after all taxes have been paid, but nothing significant.
If you are trying to decide between one account or the other, things to consider are:
-Does your employer offer a 401(k) plan?
-Does your employer offer a 401(k) match? If so, you should deposit enough to get the matching money.
-Do you have an emergency fund? The balance deposited into a Roth IRA can be withdrawn in an emergency without penalty.
Answering these questions can help make it clearer which savings fund is a better choice for you. There is nothing that says you cannot have both a 401(k) and a Roth IRA. Millions of people have both if you qualify for both.
Roth IRA or 401(k)
No matter whether you choose a 401(k), Roth IRA or both, starting to save early is the key.
Assume the following criteria for a 401(k) plan:
Contribution Period = 35 years
Annual Income = $70,000 a year increasing 3% each year
Beginning Balance = $0
Contribution Amount = 10% of salary invested annually
Employer Match = 3% of 100% of annual salary
Annual Interest Rate = 7% annually
You will have $ 1,417,255.11 in the bank at the end of 35 years. If you assume a 15% tax bracket, you have roughly $1.2M after taxes.
Assume the following criteria for a Roth IRA:
Contribution = 35 years
Beginning Balance = $0
Contributes $5,500 until age 50 and $6,500 until age 65
This person will have $840,412 at age 65 and can withdraw $63,295 annually for the next 30. The money is tax-free at withdrawal.
If the above person starts saving at age 25 (just 5 years earlier) they will be able to withdraw $90,508 per year tax-free.
Consider These Things
If you are in a high tax bracket and need to reduce your taxable income, contributing as much to your 401(k) as you can afford (there are limits) is a good option.
If you want to be able to access your money for emergencies or you don’t want to have to worry about paying taxes after you retire, the Roth IRA is a good option.
If your budget allows, you can contribute to an employer sponsored 401(k) plan as well as a Roth IRA. The most important thing is to start saving.
Both a 401(k) and a Roth IRAs are money in the bank.