If you’re in the working world, putting away a bit of your paycheck for retirement is essential. Even if you’re in your 20s, you won’t be financially prepared if you don’t start saving now. While you might be thinking that you can’t plan that far ahead, opening a 401(k) with your employer or a Roth IRA is easy. The money from a 401(k) is automatically deposited pretax from your paycheck, while you can schedule deposits to your Roth IRA.
But is one option better than the other? It all depends on your financial situation and when it’s more advantageous for you to pay taxes on the money.
Tax now or pay later
Before we delve any further, it’s important to lay out what differentiates these two retirement accounts:
- A traditional 401(k) takes automatic contributions from your paycheck before taxes, but you’ll pay income tax on the distributions in retirement.
- A Roth IRA is a special individual retirement account (IRA) where you pay taxes on the money going into your account, and all future withdrawals are tax-free.
The 411 on a 401(k)
The main benefit of a 401(k) plan is that it allows your retirement savings to grow untaxed until you withdraw the money for retirement. The reasoning goes that you might be in a lower tax bracket once you stop working.
Other advantages to investing with this plan include:
- You can report this amount as a tax deduction
- Everyone qualifies for this type of account
- Many employers offer a match to your contribution
- You choose from several investment options your employer offers
- Withdrawals are taxed during retirement, assumingly at a lower tax bracket.
Many people prefer this option since there’s a good chance they will bring in less income during retirement and pay less in taxes.
Pros
- Automatic tax-free deposits
- Employer match
- Tax write-off
- Higher contribution limits
- Maintained by employer
- Protected from creditors
Cons
- Fewer investment options
- No investment guidance
- The amount and terms of the match vary from employer to employer
- Required minimum distributions
- Higher fees
- Early withdrawal penalties for money withdrawn before age 59½
Roth IRA
You can only set up a Roth IRA at an investment firm, employers don’t offer this type of retirement plan. Since you have already paid taxes on the money invested in your account, all future withdrawals are tax-free after you reach 59 ½ years of age. And that includes the earnings on your investments.
The benefits and features to investing after-tax money:
- Your money grows tax-free
- You won’t pay taxes when you withdraw the money in retirement
- Investment choices aren’t limited
- You can borrow money from your account
- Low contribution limits
- You can withdraw your contributions at any time or any age without being hit with a tax bill or penalty
- If you withdraw your investment earnings early, you could be subject to income taxes and a 10% penalty*
(Legal – *Taxes and penalties are based on your age and how long you’ve had the account) - You can leave the money in your account during retirement, where it can continue to grow tax-free for your beneficiaries
-You cannot deduct the taxes you have paid on your contributions
-Not everyone qualifies
Plan for the retirement you want
By choosing to save for retirement, you have already made the right decision. But diving deeper, there are many factors to consider. See the chart below for a clear comparison of the two plans, which puts their advantages and disadvantages into perspective.
Roth IRAs and 401(k)s in a nutshell:
Source: Investopedia
“Workers in Their 20s Are at a Clear Advantage in Saving for Retirement”
The quote above comes from Matt Mondoux, CFA, CFP, CMT. He also advises, “The key is always making sure you’re taking advantage of the full company match offered. Not doing so is like leaving free money on the table.”
If you plan to stop working during retirement, you will likely drop to a lower tax bracket. That’s another important reason why a 401(k) could make the most sense. Be sure to take an employer match into account when comparing your potential earnings.
A Roth IRA may be the better choice if you think you’ll be in a higher tax bracket after retirement
You can receive more investment options and greater tax benefits with a Roth IRA. And if you foresee being in a higher tax bracket later on, paying the taxes upfront works to your advantage.
If you qualify for a 401(k) and Roth IRA, contributing to the two accounts is the best of both worlds.
This could be the chance of a lifetime
By giving your money more time to grow, your potential earnings could increase tenfold. And that provides a better chance for you to make the most of your time during retirement.
There is no downside to planning ahead. But if you keep putting it off, you’re only hurting yourself. Before making such an important decision, you might want to speak with a financial professional. They can take a holistic view of your finances and goals to devise a plan that’s right for you.
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FAQ section based on questions Google suggests:
Is it better to have a 401k or Roth IRA?
The ideal choice is to invest in your 401(k) up to the employer match and then open a Roth IRA, if you qualify. Your goal should be to invest 15% of your gross income for retirement.
At what age should I open a Roth IRA?
As soon as you start earning income. The earlier you start, the higher your earning potential is on your contributions. That means more money for your retirement when you will have plenty of time to enjoy doing those things you love.
What are the tax advantages of a 401k?
You can set aside part of your paycheck before federal and state income taxes are withheld, which means the money you invest is tax-free. You don’t pay taxes until you start taking the money at age 59 ½ or older. The theory behind this is that some people expect to earn less in retirement than during their working years—which would put them in a lower tax bracket.
What is the difference between a Roth IRA vs a traditional 401k?
A traditional 401(k) is a pretax savings account. The funds are taken from your gross income and aren’t taxed until you start spending the money at age 59 ½ or older.
On the other hand, a Roth IRA is a post-tax retirement savings account. That means your contributions have already been taxed before they go into your account, so you won’t owe money when you take them out.
What is the biggest difference between a 401k and a Roth IRA?
They are taxed differently. A traditional 401(k) takes money from your gross income, which means you don’t pay taxes until you start spending the money. A Roth IRA takes money that is already taxed. When you start spending it, you won’t owe taxes.
Another difference is that everyone qualifies for a 401(k) while a Roth IRA contains exclusions. If you earn too much or too little, you will not be able to contribute to this type of account.
Can I have both a Roth IRA and a 401k?
Being eligible for tax-advantaged contributions to both plans in any given tax year depends on your financial situation. If you qualify and have a little money to invest, opening both a Roth IRA and a 401(k) can help you maximize your benefits.
How much should I put into a Roth IRA?
Breaking it down, you can contribute $542 every month to avoid the Roth IRA’s $6,500 limit. So, if you can afford to contribute around $500 a month without going into debt, that is a sound strategy. Otherwise, you can set aside the recommended 20 percent of your income.
How much can I contribute to both a 401k and Roth IRA in 2023?
You can contribute up to $22,500 to a 401(k) plan. If you’re 50 or older, the annual contribution maximum increases to $30,000.
For a Roth IRA, you can contribute up to $6,500.
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