Roth IRA and 401 (k) are the two most popular retirement accounts. Choosing the strategy that best suits your circumstances can be a difficult decision.
This article will compare the benefits of choosing a Roth IRA versus a 401 (k) and help you decide where to save and invest in the long term.
What is the difference between investing in a Roth IRA and a 401 (k)?
The first major difference between investing in a Roth IRA and a 401 (k) plan is how you are going to contribute. With a Roth IRA, you have to open an account (usually on the website of a popular online brokerage company) and then fund it. The contribution often comes from your checking or savings account and must be made in cash.
With 401 (k), contributions come directly from your paycheck through your employer’s payroll system. New hires typically choose 401 (k) contributions to complete enrollment in benefits. There are fewer investment options in the 401 (k) plan, but there is usually a selection of stock and bond funds to choose from. Many plans now also offer a set of date-specific mutual funds.
The second major difference between the Roth IRA and the 401 (k) is the tax regime. Roth contributions are post-tax while regular 401 (k) payment deferrals are pre-tax. This means that you pay income tax today when you invest in a Roth IRA, while you receive a tax deduction for the current year when you make 401 (k) contributions.
Pull out the match 401 (k)
It’s also important to consider how the agreed employer contributions work under the 401 (k) plan. Many firms have related policies; for example, 50% of the first 6% of contributions. This means that if you make $ 100,000 and contribute $ 6,000 a year to your 401 (k), your employer will donate an additional $ 3,000 to you for free. In this scenario, this is an instant 50% refund of your money! This is a great deal. Employers’ contributions are paid before tax, whether you choose pre-tax regular contributions or Roth. Of course, there is no employer overlap with the Roth IRA.
Early withdrawal rules
Here’s a situation where a Roth IRA beats a Roth 401 (k): early withdrawals. Usually there is a fine for pulling money out of a retirement fund. This is not always the case for the Roth IRA as you can withdraw your contributions at any time. The IRS also allows you to withdraw profits from a Roth IRA without penalty in some situations. Some of the most common reasons for the early withdrawal of earnings from the Roth IRA include money for the first home purchase, the cost of a qualified education, qualified medical expenses, and disability or death. You can view a list of all IRS reasons here.
How do Roth IRAs differ from traditional 401 (k) besides traditional 401 (k)?
Another trend that has emerged in the 401 (k) space is the ‘Roth’ 401 (k) proposal. Roth 401 (k) works like the Roth IRA in some respects and 401 (k) in other respects. We know that “Roth” means that contributions are made after taxes. Roth 401 (k) is just another employer sponsored retirement account, but the money in this account is already taxed and will grow tax-free upon retirement.
Roth IRAs offer withdrawal flexibility compared to Roth 401 (k)
The Roth IRA differs from the Roth 401 (k) in that contributions made to the Roth IRA can be withdrawn without paying taxes and penalties at any time. Inside Roth 401 (k), the plan member faces a 10% early withdrawal penalty for withdrawals before age 59½.
Annual contribution limits
The Roth IRA also has a lower annual contribution limit than the Roth 401 (k). According to the IRS, the maximum IRA contribution for 2021 and 2022 is $ 6,000 ($ 7,000 for those aged 50 and over). The maximum you can invest in a 401 (k) plan is $ 19,500 in 2021 ($ 26,000 for those 50 and over) and $ 20,500 in 2022 ($ 27,000 for those 50 and over). older). These limits apply to combinations of contributions to a traditional IRA and a Roth IRA, and to regular and Roth 401 (k) contributions, respectively.
Beware of Roth IRA Income Limits
You will not be able to contribute to the Roth IRA if your income exceeds certain thresholds. Roth 401 (k) has no income cap. For a Roth IRA, retirees should familiarize themselves with the rules set by the IRS. High-income individuals and couples must forecast their adjusted gross income for the year before contributing to the Roth IRA.
Roth 401 (k), Roth IRA and pre-tax 401 (k) retirement accounts
Source (table): https://www.irs.gov/retirement-plans/roth-comparison-chart
Required minimum distribution rules
Mandatory minimum allocations (RMDs) are something to keep in mind with 401 (k) plans. Your RMD is the minimum amount you must withdraw from your retirement account each year. The IRS does not allow retirees to leave money in a tax-protected car. They want a piece of your egg! Retirees should usually start accepting traditional IRAs and regular 401 (k) payments at age 70½. The SECURE Act changed the age of onset of RMD, moving the mandatory allocation to 72 for those who turn 70 on or after July 1, 2019.
Roth 401 (k) is subject to the RMD plan rules, so be sure to know the details of your plan. The best news is that Roth IRA money is not subject to RMD regulations. What’s more, retirees can migrate their Roth 401 (k) to a Roth IRA to bypass the need for withdrawals.
When should you choose one against the other (or a combination of both)?
Your situation is paramount when choosing a retirement savings strategy (as are most aspects of long-term financial planning). However, it would be wise to get the most out of these tax-free accounts. Capturing a 401 (k) company match is usually a good first move. Many Millennial and Gen Z contributors should review their entitlement policies. If a company requires an employee to stay with the firm for five years before a match is made, it might not make sense to put your first savings into a plan. However, contributing 401 (k) before the match is often a good first step towards saving for retirement.
Contribute to a 401 (k) match plan then head to the Roth IRA
After you’ve won a match, focusing on making the most of your Roth IRA can be a tricky move. Roth IRAs are more flexible than 401 (k) plans as you can withdraw your contributions at any time without paying taxes or penalties. With more investment options – often at a lower cost – you can keep more of your IRA versus 401 (k).
“Once a person has saved enough 401 (k) to take advantage of full company compliance, it usually makes sense to set aside additional dollars for a Roth IRA (if their income allows it),” says Eric Simonson, financial planner. and founder of Abundo Wealth. “Benefits of a Roth IRA over 401 (k): 1) You are an account holder, not a member of the plan. 2) You have a lot more investment opportunities to add diversification and potentially lower your fees. And 3) Roth IRAs have better withdrawal options, and those dollars are potentially more affordable than 401 (k). ”
Use online resources to help you choose how you save for retirement
So the combination of 401 (k) and Roth IRA makes sense to many. High earners are likely to be better off making pre-tax contributions (such as traditional IRA contributions and regular 401 (k) deferrals). In contrast, younger, lower-income workers may be better suited to Roth’s after-tax selection of contributions. Here’s a tip: be sure to research online calculators to determine which contribution type and account type are ideal for your situation.
How should the over-economist make pension contributions?
Superguards can contribute to both the Roth IRA and 401 (k). In 2022, an employee under 50 could hypothetically invest $ 6,000 in a Roth IRA and $ 20,500 in a 401 (k). The $ 6,000 IRA limit can be composed of Roth and Traditional IRA contributions. The same logic applies to 401 (k) contributions – the $ 20,500 payroll deduction from a plan member can be a mixture of pre-tax money and Roth money.
Knowing yourself and strategies for retirement savings
Always check your financial situation over the years, or hire a financial advisor, such as a certified financial planner, to help you sort out your unique circumstances. The cost of hiring a financial consultant may be less than you think, as more consultants offer subscription-based pricing or charge a flat fee to create your personalized financial plan.
It is important to know your marginal income tax rate as well as your emergency savings level. A clear understanding of your savings priority hierarchy will help you optimize long-term wealth creation.
Ask yourself: Are you thrifty or wasteful? People who find it difficult to save time should consider Roth’s contribution. Thanks to the Roth IRA and Roth 401 (k) contributions, retirement savings are made after taxes, so taxpayers do not receive higher tax refunds. Frugal people will not be tempted to immediately spend the money they save on taxes. If you are a diligent investor, making your pre-tax contributions and simply investing your current year’s tax savings in a taxable account may make more sense.
Best to fall on taxes
Here’s an example. Suppose that retirement savings of $ 5,000 have been transferred to the Roth IRA and the marginal tax rate per person is 22%. Basically, you are paying $ 1,100 in income tax this year, but your account will grow tax-free forever. If you have a pre-tax account, that $ 1,100 will be reflected in your tax refund next spring when you apply. Natural sponsors may be tempted to make a big purchase, saving on taxes. Meanwhile, that $ 5,500 is subject to income tax upon retirement.
Special circumstances for families of foreign origin
Depending on your status as a US citizen, it is important to consider additional factors that can significantly affect your potential tax benefits when choosing a Roth IRA over a 401 (k). A financial advisor who specializes in dealing with immigrants and foreign nationals can prove invaluable in minimizing the risk of losing tax benefits.
“With the foreign born families I work with, there is always the possibility that they plan to return to the country where they were born. In this case, we decide whether the foreign country recognizes the tax-free nature of the Roth IRA, ”says Jane Mefam, financial planner and founder of Elgon Financial Advisors. “Some countries, such as Germany, do not and will tax their Roth IRA account again on withdrawals. In this case, I would avoid having the client open a Roth IRA and leave it in a 401 (k) account. “
Conclusion and call to action
When deciding on pre-tax or Roth contributions, compare your current tax rate with your tax rate at retirement. If you are in a relatively high tax category today, pre-tax deductions may be a better option. Also, compare the flexibility of Roth’s IRA to the sometimes rigid rules of the 401 (k) plan. If you may need to withdraw money from your retirement accounts, a Roth IRA is the best option. Of course, knowing your 401 (k) plan’s employer guidelines is essential to getting the most out of your retirement savings.
This post was originally published on Wealth of Geeks.