When it comes to retirement accounts, it’s critical to give careful thought into where you put your hard-earned money. While we often consider which investments we choose, it’s less often that we focus on which accounts best serve our financial goals. This article will focus on two of the most well-known retirement accounts as we discuss the differences of traditional 401k vs Roth IRA.
Both of these options are popular tax-advantaged retirement savings accounts. In layman’s English, they are long-term savings accounts with restrictions on taxation, investment, and withdrawals. The purpose is to make it easy to invest in your future by holding your money in a stable portfolio. Furthermore, the high penalties for early withdrawals serve as added incentive to leave your funds be so they can grow.
Let’s start with a quick rundown of each.
What is a 401k?
A 401k is an employer-sponsored retirement account named after Internal Revenue Code, section 401(k). (While Roth 401(k)s do exist, this article will focus on traditional 401(k)s, which are far more common.)
Contributions and Limits
In a traditional 401k, employees make contributions into their account on a pre-tax basis. The money in the account comes from your gross income, rather than your net (post-tax) income.
Many employers provide a matching contribution (up to a limit) based off a percentage of the employee’s income. For instance, the most common employer match is 50 cents for every dollar you contribute (50%). This perk is available up to 6% of your total annual salary.
Keep in mind that there are limits for 401k contributions. While the employer match doesn’t count toward your limits, the matched amount does count toward the yearly allowable total cap. In 2020, this combined contribution limit is set at $57,000 for under-50s and $63,500 for over-50s.
Over the years, your funds will grow (hopefully). Eventually, you will pay ordinary income tax on withdrawals on the back end.
Withdrawals and Required Minimum Distributions
It’s important to remember that you have to wait until 59 years, 6 months of age before you can withdrawal funds without the 10% penalty. (This applies to all retirement accounts minus 457(b)s.)
However, if you’re an individual who continues working beyond the retirement age, there’s another factor to consider. On 1 April following your 72nd birthday or retirement, whichever comes second, you must take required minimum distributions (RMDs).
Depending on your plan provider, the investment options available to you may vary wildly. The important point with a traditional 401k is that regardless of the fund(s) you select, all returns will be tax-deferred.
Traditional 401(k)s at a glance
- Employer-sponsored, tax-deferred account
- Combined contribution limit of $57,000 under 50 years old; $63,500 over 50 years old
- 10% penalties on withdrawals before 59 years, 6 months of age
- Required minimum distributions start 1 April the year after you retire or turn 72
- Investment options vary widely and are limited to provider offerings
What is a Roth IRA?
The main distinction between a traditional 401k vs a Roth IRA is in the definition. Roth IRA stands for Individual Retirement Account. A Roth IRA is a contract between a financial institution, such as a bank or a broker, and an individual. This allows you to customize your investment choices to your preferences, as there is no plan provider to dictate options.
It’s important to note that unlike a 401k, not everyone is eligible to make contributions into a Roth IRA. Eligibility is dependent upon your adjustable gross income. This means that if you make above a certain annual income, you will be “phased out” from Roth IRA contributions. Additionally, if you are eligible to contribute, there is still a maximum amount you can invest in a given year. This maximum contribution is based upon your adjustable gross income. You can find this information here on the IRS website.
Contributions and Taxation
The primary difference between how Roth IRAs and traditional 401(k)s function lies in the tax rules. Unlike traditional retirement accounts, where you make contributions pre-tax, you can include Roth contributions in your income the year you contribute. Additionally, any gains on your investments will not be taxed while your funds remain in the account.
Due to the taxes on the original contribution, taxation on withdrawals is different as well. Assuming that you make qualified withdrawals from your Roth IRA, your funds come out tax-free. However, unlike your 401k, there are a few ways to avoid taxes and penalties on early withdrawals, such as:
- Taking withdrawals due to a permanent disability
- A beneficiary makes a withdrawal after your death
- You make a withdrawal and use the funds to buy, build, or rebuild your first home
There are other circumstances to avoid the penalties (but not the tax), but we won’t cover them in this article.
Another important tidbit to know is that you are never required to take a minimum distribution from your Roth IRA. If you choose not to touch this account during your retirement, the funds can continue to grow until your beneficiaries inherit your estate.
Roth IRAs at a glance
- Individually sponsored, post-tax account
- Annual contribution limit of $6,000
- Penalties and taxes applied on withdrawals before 59 years, 6 months of age
- Exceptions made for special circumstances, such as permanent disability
- No required minimum distributions, ever
- Only your preferences limit your investment options
401k Vs Roth IRA: Which is Better for You?
For most people, it’s wise to choose a Roth IRA vs a 401k. This is due to their increased flexibility and taxation at current income rates. (In other words, your money is taxed within the income bracket in which it was earned). Nevertheless, if you don’t qualify to contribute to a Roth IRA, you likely won’t be able to find a better alternative than a traditional 401k on your own.
However, if you are eligible for both a Roth IRA and a traditional 401k, it’s time to ask the question. Which investment option makes the most sense for you?
The answer, quite simply, is both. Diversification – in which you invest in multiple types of opportunities – is incredibly important in building a robust portfolio.
Diversifying Your Retirement Portfolio
Under current tax code, it is permissible to contribute to both types of retirement accounts in the same tax year. However, you must still adhere to the maximum contribution amounts on both accounts. In 2020, the max 401k contribution sits at $19,500 if you are under 50 years old. The maximum IRA contribution currently sits at $6,000.
Diversification is a common term in the investment world. Unfortunately, few people consider the importance of diversification across tax-status withdrawals from investment accounts. If you have the opportunity to diversify your retirement accounts, take a hard look at your financial future. For most individuals, the benefits are quickly clear.
Even if you’re unable to max out either account, it may be worth considering paying into the two simultaneously, as you can use the traditional 401k payments to lower your adjusted gross income. Let’s break this down.
401k contributions are calculated pre-tax. This means that the government does not consider these funds in your gross income, thereby deducting the contribution from your total income.
In some cases, your contributions may be enough to lower your adjusted gross income into a Roth IRA-eligible bracket. This allows you to simultaneously contribute to the tax-free retirement income sleeve of your portfolio.
Diversification of your retirement accounts makes the most sense if you’re either:
- Currently slotted in a low-income tax bracket
- Expecting to reside in a higher tax bracket come your retirement
How to Use Both a Roth IRA and 401k To Your Benefit
When the time comes to finally spend your hard-earned monies during retirement, ideally, you should deplete the traditional 401k assets first. This gives your Roth assets more time to accumulate interest. You should dip into your Roth assets only once you have emptied your traditional 401k account. This approach allows you to maximize your tax-free income potential during retirement.
At the end of the day, you should make financial decisions that make sense for your future. The choices you make about your retirement accounts affect not only you, but your spouse, children, and other loved ones. When you pass, your estate will continue to benefit those named with the resources you spent a lifetime accumulating.
To make it short and sweet: if your employer offers a 401k-matching program, you have an excellent opportunity to save money – tax-free – at your fingertips. While a Roth IRA doesn’t offer the same benefits as other accounts, it may make sense for different income brackets. However, the ideal is to diversify and expand your retirement investment portfolio as far as is possible. This means that those who can take advantage of both options should in order to secure a well-funded retirement.
Financial Professional would like to remind you that you should always consult a tax professional before making any tax-related decisions. On the other hand, don’t underestimate the power of making wise decisions with the free tools at your disposal.