At various points in life, it becomes necessary to choose a side. And one such choice you need to make is deciding between Roth IRA and 401K – a decision that will probably significantly affect your future. So which is better?
Regardless of the retirement dreams, money is an integral part of those aspirations. And the fact is that Roth IRA and 401K are ideal means of realizing retirement wealth. Upon understanding how each of these plans works, you will appreciate how you can use them to optimize your savings. Your choices today can make you thousands, possibly millions of future dollars.
Below, we are going to take a look at the Roth IRA and the 401K, so let us look at what avenue is better, Roth IRA or 401K.
401K – What Does It Mean?
401K plans are retirement savings schemes that most employers provide as a means of encouraging a saving culture among their employees. Essentially, you inform your organization of the amount you wish to invest in the 401K – often in salary percentage form or a certain amount every payday. The amount is then taken from your paycheck and automatically added to your retirement savings.
Benefits of 401K
It has increased contribution limits
As of 2022, it is possible to invest a maximum of $20,500 annually in a 401K, 403(b), or in many 457(b) schemes – excluding employer match. This is a significant amount! And if you are above 50 years old, you may add an extra $6,500 annually, making a $27,000 total.
Employer match
Employer match is arguably the best part of 401K plans, where employers match investments to a particular amount. This is a direct 100% return on investment. Matching is not a government requirement; therefore, not every employer will provide it. If your employer does, take maximum advantage of it and do not overlook the free funds.
The contributions you make reduce the taxable income
You end up paying a reduced income tax because of the pretax dollars you invest in the 401K. For your peace of mind, the 401K investment is ultimately yours. You can roll over the 401K plan to Roth IRA if you change your employer.
Shortcomings of 401K
Though 401K is an excellent means of retirement saving, you should familiarize yourself with its disadvantages too.
They have a reduced mutual funds option
Typically, your employer will hire a third-party admin to handle the company’s retirement plan. Such an admin chooses and picks the mutual funds you get to invest in, thereby limiting the options.
You have taxed retirement withdrawals
The tax breaks received on 401K contributions have a catch to them. Since you contribute to the 401K account using pretax dollars, you do not pay taxes on your contribution but will incur the taxes in your retirement. This can lead to hefty taxes depending on your retirement tax bracket.
Require Minimum Distributions (RMDs)
Funds in your 401K account cannot stay there forever. Starting at 72 years old, you are penalized if you fail to withdraw a particular amount annually. Additionally, you get penalized for withdrawals made before 59 ½ years of age.
Waiting duration
Are you a newbie to the organization? Then you might need to wait before participating in 401K plans or getting an employer match.
Roth IRA – What Does It Mean?
An Individual Retirement Account or Roth IRA is a savings strategy you can start independently. The term Roth should instantly perk up your ears since Roth IRA lets your savings increase tax-free. This implies that upon turning 59 ½ years old, you get to withdraw funds from the account without owing even a single tax penny.
Benefits of Roth IRA
Roth IRA has the following advantages over 401K.
Tax-free growth
Different from 401K, contribution to Roth IRA uses after-tax money. This means that since the investment into the Roth IRA account is already taxed, the funds in your account increase tax-free. Withdrawal at retirement does not need you to pay any amount in the form of tax.
The deal here is that upon attaining the retirement age, most of the funds in the Roth are growth. Therefore, the growth is not taxed, meaning you get to keep the amount that would have otherwise gone to the government.
Additional investment options
Roth IRA does not have limitations by third-party administrators who decide the funds you get to invest in. You have an array of mutual fund options to pick from. With the extra options, you are also able to make better choices.
Freedom from your employer
Different from typical workplace retirement plans, you are free to open Roth IRA any time you desire. And regardless of your employment status, your Roth IRA is not affected in any way. So it is unnecessary to roll anything over or keep track of 401Ks left from your previous jobs.
No Required Minimum Distributions (RMDs)
You get to maintain your funds in your Roth IRA forever if you so desire. That implies that you could facilitate the continued growth of your money over an even longer duration.
Spousal IRA
Are you married but not both of you make money? Worry not, for it is still within you to create a Roth IRA for your nonworking spouse. The earning spouse can make investments in both spouses’ accounts – to a maximum of the total amount! In contrast, only an employee of the organization providing 401K can contribute to the 401K.
Shortcomings of Roth IRA
Though Roth IRA might sound so impressive, it still is associated with several disadvantages you should know.
You have reduced contribution limits
You only get to invest a maximum of $6,000 annually in Roth IRA or $7,000 if you are 50 years or older. Comparing this with the 401K contribution limits, you might realize why Roth IRA and 401K are more efficient together.
Income limits
Though Roth IRA might be fantastic, there is still a probability that you might be ineligible to save in such a plan. If your MAGI (Modified Adjusted Gross Income) is more than $144,000 as an individual or over $214,000 for a married couple jointly filing, you are thus ineligible for the 2022 Roth IRA contribution. However, you still have a way out in a traditional IRA.
The five-year statute
This rule will not be a problem for many people, as it states that you cannot withdraw from Roth IRA till at least a five-year duration elapses since your initial contribution. Doing so leads to incurring penalties and taxes. Furthermore, similar to 401K accounts, you are penalized if you take money from your Roth IRA before attaining 59 ½ years of age.
Conclusion
If you are weighing your options and deciding whether to invest in a Roth IRA or 401K, you do not have to choose either since you can have both. Professionals say that the initial account you need to take advantage of is the 401K account if you are eligible for one at your workplace.
Ensure you invest enough to receive your employer match first. This is free money you do not wish to miss out on. You can then progress to Roth IRA and try maxing out the annual $6,000 if eligible. If you still have sufficient funds after this, return to the 401K and get it to the whole annual limit of $20,500.
