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Choosing Between a 401(k) and a Roth IRA

Choosing Between a 401(k) and a Roth IRA

Choosing Between a 401(k) and a Roth IRA

For everybody planning their retirement years, two main options come to the forefront, Roth IRA and 401(k); both definitely worth considering. The debate regarding which one to choose is everlasting and, most of the times, the answer is not as straightforward as one might think. However, there are also cases when opting for either a 401(k) or IRA retirement plan is a one-way street. To be able to make a sound and educated choice, it is critical to have a working understanding of both options, what each one entails, and even whether you can have both at the same time. Let’s delve a bit deeper into this matter to help untangle the knot.

What is a 401(k)?

Defined under subsection 401(k) of the IRS code (hence the name), a 401(k) is an employer-sponsored retirement plan that allows you to save and invest some money of your paycheck before taxes are applicable. The process is as follows:

  • You sign up for a 401(k) plan in your workplace.
  • You select the investment options within the plan that will serve your best interests.
  • Your employer takes money out of your paycheck and deposits it in your plan. This is money before income taxes are taken out.
  • Once you reach retirement age, you can withdraw the money.

Notes about withdrawing your contributions: You will need to pay income tax when you withdraw your retirement money. This is decided with your best interest in mind, considering that you will most likely be in a lower tax bracket in retirement than when you are in your prime earning years.

Early withdrawals (those made before you are 59½ years old) are usually taxed as ordinary income + 10% penalty fee. There are exceptions, though, which include a qualified domestic relations order after a death or divorce, separating from service when you reach 55 years of age, and disability.

In 2016, you could contribute at most $18,000 to your 401(k) plan while the max total amount both you and your employer can contribute in the same year was $52,000. Nevertheless, right now, there is no upper-income limit on who can contribute to a 401(k) retirement plan.

Why consider a 401(k)?

For starters, you may as well be offered an employer match. This means that your employer will match your contributions (up to a certain percentage). If you are thinking this is an opportunity for some free money, you are right. If, say, you contribute 10% of your gross salary to your 401(k), your employer might match your contributions (usually between 3%-6% of your contribution). This is one major difference between a 401(k) and Roth IRA retirement plan, given than Roth IRA plans are funded with your after tax money.

That aside:

  • You can contribute a lot more money each year with a 401(k) plan than with any other plan. Let us not mention that your contributions could lead to tax savings during each year you contribute.
  • In regards the way taxes are paid on your withdrawals and, of course, your contributions, a 401(k) plan reduces your tax liability during each year you contribute (since it is funded with pre-tax dollars). You will be taxed upon withdrawal, though, at the current tax rate at the time.
  • If you are near your peak right now and do not expect any income growth from now to retirement, you will potentially be in the same (or lower) tax bracket when you retire, which favors the 401(k).
  • The money can be taken out of your paycheck directly, so things are made easier and less stressful for you. You can find details about contribution limits and more on the IRS.gov website.
  • If you expect tax rates in the future will be lower than today, then a 401(k) is your best bet, considering that you will not be taxed on your contributions until the time you retire.

What is a Roth IRA?

With a Roth IRA (Individual Retirement Arrangement) retirement plan you set up an account with an investment firm directly. You get to pick your investment options with the broker you have chosen and then deposit after-tax money into the Roth IRA. This could be money from your checking account or any other. Provided you have had the plan for, at least, five years, and that you are older than 59½ years old (basic requirements you need to meet), you can withdraw your deposits and investment gains without having to pay any taxes for it.

Additionally, you can make early withdrawals and not be subjected to a penalty fee if you want to make a down payment on your principal residence or pay for your child’s education. As for the maximum annual contribution to a Roth IRA you are allowed to make, it was $5,500 in 2016. This is applicable to ages below 50, though.

However, not everybody can contribute to a Roth IRA. There are income limits that dictate whether you can contribute the full amount, or any amount. For example, you must make up to $116,000 individually to be eligible for a full contribution and up to $131,000 to qualify for a partial contribution. For joint filers, you need up to $183,000 or $193,000 to be eligible for a full or partial contribution respectively.

Why Consider a Roth IRA?

First of all, your withdrawals are tax-free. This is because you have already funded your account with after-tax money. Other than that:

  • You can withdraw your contributions without penalty at any time, once you have reached 59½ years of age.
  • You choose your investment options and brokerage firm. Unlike with a 401(k) plan, a Roth IRA is not tied into whatever management and investment options your company has chosen to offer you.
  • You can make tax-free withdrawals (up to a lifetime max $10,000 in earnings) to acquire a first home.
  • You can make tax deductible contributions to a Roth IRA even if you participate in a 401(k) or other retirement plan.
  • You get to choose your plan’s manager.
  • Roth IRA contributions will not affect your taxable income in the year you are making a contribution since the money you contribute has already been taxed.
  • If you expect your income to increase anytime between today and your retirement years, then you will most likely be in a higher tax bracket when you retire, which is beneficial to you if you have a Roth IRA.
  • If you speculate that tax rates in the future will go up, a Roth IRA is your best option (tax-free future distributions).

Three Strategies to Maximize your 401(k) or Roth IRA Contributions

Chances are that Social Security funds will not be enough to provide you with a decent life during your retirement years. Your cash savings, on the other hand, will not be able to give you the returns you could get if you had invested it all along. So, it is paramount to contribute to one type of retirement account (if not more), depending on your individual situation and selected plan. To boost your contributions to your 401(k) or Roth IRA plan (or both, if you are able to contribute to them and meet certain conditions), here are some strategies to consider:

  1. Max out For Your 401(k) & Contribute to a Roth IRA – If you have extra money to invest and your 401(k) offers plenty of options, low fees, and an employer match on your contributions, then this is a great strategy to lower your tax liability and maximize your contributions overall.
  2. Contribute a Percentage Equal to your Company Match & Start Funding your Roth IRA – This will work like a charm if your employer has offered you a company match but your 401(k) does not have the best options. You can still benefit from your employer match by contributing a sum that equals to what the company has pledged to contribute and then begin making contributions to your Roth IRA.
  3. Contribute the Same Amount of Money to Both 401(k) and Roth IRA – If you feel unsure about which type of retirement plan to focus on, then make a commitment to contribute to both your 401(k) and Roth IRA every single month. You get to decide just how much money (% of your income) you can easily contribute to both accounts.

How Close Are You to Retirement?

You can estimate when you will be able to retire if you have a general idea what your expenses and, of course, income might be in the next years (or decades – depending on when you start saving for your retirement).

A key consideration is how you want to live your retirement years, meaning how much you would need to spend each year to have the lifestyle you wish. Financial planners often estimate that people  plan to spend around 80% of your current income when you reach retirement. This is because you spend less on retirement savings, work attire and other word-related, daily expenses, payroll taxes, and debt (assuming you have paid off your debt or, at least, most of it before retiring).

However, you also need to take into account extra expenses that you do not have now, such as lifestyle purchases (i.e. a holiday home or boat) and travel expenses. Of course, you will get some income from Social Security (and possibly a pension), but you will need to make sure you have saved enough to have the kind of life you are dreaming of, when you retire. In this case, it might be a good idea to plan to spend 100% of your current income (or maybe more) and act accordingly.

Summing It All Up

As with many things in life, there is no one-size-fits-all option and this includes choosing between a 401(k) and Roth IRA. To figure out which account might be best for you, you need to do some research on your own. Explore the advantages and disadvantages of each plan, depending on your current and future situation and consider how you have planned to spend your retirement years. Needless to say, time is of the essence. The earlier you start saving and investing money for retirement, the better off you will be.