Roth IRA vs. 401(k): Fundamental Differences

Roth IRA vs. 401(k)

There is a wide range of long term retirement plan that can create sustainable sources of income that can support your lifestyle in retirement and Roth IRA and 401k are two of such plans that are worth comparing.

Both are retirement investment savings that workers can benefit from tremendously. Though there are similarities and there are differences between them, you can make regular contributions to both plans at the same time provided you meet certain requirements. They are both excellent tax-efficient ways to save for your retirement, as an employee.

Today we are going to pit the Roth IRA against the 401(k) to help you come up with a plan optimized for your unique situation.

So, what is a Roth IRA and a 401(k)?

Both are retirement investment savings that workers can benefit from tremendously. Though they share many similarities and there are differences between them, you can make regular contributions to both plans at the same time provided you meet certain requirements. They are both excellent tax-efficient ways to save for your retirement, as an employee.

A Roth IRA is a self-directed retirement account while 401(k) is an employer-sponsored account. There are other fundamental differences between the two which we shall be delving into shortly. But first, let’s define the terms.

Roth IRA

A Roth IRA is a qualified individual retirement plan funded by after-tax income that offers tax exemptions on your earnings from investments. A Roth IRA encourages you to save by providing you tax incentives. Your contributions and any gains from them are tax-free. This means that when you retire, you won’t have to pay tax on withdrawals from your Roth IRA.

A Roth IRA is not an investment, but rather an account that holds your investments. When you open a Roth IRA account at a brokerage firm or a bank, you select the investments that will be made on your behalf. This could include stocks, bonds, mutual funds, exchange-traded funds (ETFs), etc.

401(k)

A 401(k) is a savings account offered by employers who automatically withdraw contributions from your paycheck to invest in any fund of your choice from a list of available investment vehicles.

The 401(k) derives its funky-sounding name for section 401(k) of the Internal Revenue Code which covers the savings plan.

Features and Benefits

The Roth IRA and 401(k) are both tax-advantaged retirement savings plans. And that is where the similarity ends. They all have their different features and advantages which you ought to understand to make the most of your retirement savings plan.

Roth IRA vs 401(k) – Fundamental Differences

Retirement PlansContribution Limits (2019)Tax Treatment
Roth IRA

  • For under 50 maximum contribution is $6000 and $7000 for those over 50 years old


  • After tax investments.

  • Withdrawals are not taxed and allowed at any time. Withdrawals on earnings may be subject to penalty.

401k

  • For under 50 years old, the annual limit is $19000 and for 50 and older can contribute an additional catch up contribution of $6000.


  • Pre Tax investments

  • Contributions are tax deductible when you file your tax return.

  • Distributions are subject to income tax.


Contributions

For the Roth IRA, the maximum annual contribution is $6,000 as of 2019 if you are under 50 and $7,000 if you’re over 50. That is, you can only contribute $6,000 to the plan in a calendar year. But if you’re older than 50, the government allows you to meet up by increasing your limit by $1,000. You can only contribute what you earn in a given year in a Roth IRA. Contributions to the Roth IRA has no age limits. You can continue with your contributions as long as you earn income even if you are past 701/2 years old.

Contributions to the 401(k) currently have an annual limit of $19,000 for people below 50. While those 50 and older can contribute an additional catch-up contribution of $6,000 annually.

However, the beauty of the 401(k) plan lies in the fact that your employers can match your contributions. That is, for every amount you contribute from your salary, your employers add a certain percentage of that amount to your total contribution. In other words: free money.

For example, if you earn a salary of $100,000 and you decide to contribute 6%, and your employer agrees to match 50% of your contribution. Essentially, you are getting an additional free $3,000 to your $6,000 contribution, making it a total of $9,000. This is literally free money. So not only do you get the free benefit of tax deduction, but you also get free money from your employer. However, you have to remember that the 401(k) plan is tax-deferred – you will still have to pay income tax, unlike the Roth IRA.

In 2019, the limit for the combined employer and employee contribution stands at $56,000. For the employees 50 or older, who are eligible for catch up contribution, the limit is $62,000 per annum.

Tax Treatment

With a Roth IRA, you are investing using after-tax dollars. Which is to say your contribution is from your net income – after all taxes have been deducted. A Roth IRA helps your money grow tax-free so you can access it in retirement. Let’s say you have contributed $100,000 in a Roth IRA which was invented in a mixed portfolio. So the money grows tax-free to $145,000 at the point of retirement. The $45,000 is yours at retirement. There is no income tax taken from it because it has already been taxed.

This feature of the IRA offers up significant wealth preservation advantages in two ways. Firstly, you may not know the tax bracket you’ll end up in in the future. This will be especially advantageous if you end up a high-income earner. Secondly, the tax rates could go through the roof in the future. Saving with a Roth IRA hedges against that. You couldn’t care less if the tax rates were 90% or more. You have all your retirement money to yourself.

Unlike the Roth IRA, you contribute with pre-tax dollars to a 401(k) account. These contributions are, however, tax-deductible. If, say, you make $70,000, you will be taxed for the full amount. But if you decide to contribute to a 401(k) account, with $5,000 for instance, you will be taxed only on $65,000. The gains on your investment are not taxed.

When you reach the retirement age and begin to make withdrawals from the plan, the withdrawals or distributions are subject to income tax at your current tax rate. This is something to critically evaluate if you expect your income at retirement will be high.

Access to funds

With the Roth IRA, you can access your contributions at any time. But, you must be 59 1/2 years and above to qualify to withdraw any earnings on your investment in addition to the five-year rule.

The five-year rule states that you cannot draw from your earnings for 5 years starting from the first tax year of your initial contribution to the account. Still continuing with the $100,000 example, you can take out the $100,000 you initially contributed tax-free and penalty-free and without age limit. However, you won’t be able to touch the gains of $45,000 till after 5 years from the first tax year of your first contribution. When you get to the age of 59 1/2, you can withdraw both gains and contributions without penalty or taxes.

Risk comes from not knowing what you’re doing. – Warren Buffet

Unlike the Roth IRA, funds in your 401(k) are not easily accessible. While possible, early withdrawal (before you hit 59 1/2 years) from your 401(k), can be tricky. And not every employer allows that. If you must withdraw, weigh your options carefully to minimize financial loss. You pay regular income tax on every withdrawal plus a 10% early withdrawal penalty except if you are totally and permanently disabled.

There are other conditions; however, that let you withdraw from your account without the large deductions. You can borrow against your 401(k). The amount taken won’t earn anything for you, and you will pay some interest on the loan. Or if you qualify for a hardship withdrawal option, the 10% penalty is usually waived. Withdrawals due to economic hardship, to make down payments for a primary home or to pay tuition are typically considered for hardship withdrawal option. However, you’ll still have to pay the normal income tax.

Distributions

Distribution is the term used to refer to withdrawals from your retirement accounts. The Roth IRA doesn’t limit you to a minimum distribution. Unlike the traditional IRA which stipulates you take out a minimum distribution starting from age 70 1/2. You can hold the account indefinitely through your life since there are no RMDs (Required Minimum Distributions). This means that if your nest egg has grown to say $500,000, you don’t have to touch it. This can be useful for estate planning since you can bequeath it to your successors, will it to charity or do whatever you want with it. Even better, the money left over when you pass on will go to your heirs tax-free.

Withdrawing from a 401(k) after the age of 59 1/2 also referred to as normal distributions are taxed at your current tax bracket. When you get to age 70 1/2, the distributions become compulsory whether you need it or not and failure to take your distribution attracts a tax penalty of 50% on the amount you should have withdrawn. Once due for normal distribution, you can choose to take money periodically or as a lump sum.

While a lump sum withdrawal will give you a sizable amount of money to play with, remember that it goes together with an also sizable tax at once which may put a severe dent in your nest egg. You can also elect to withdraw periodically – one a month or once every quarter. The idea is to manage your money in such a way that you won’t be left with anything while you are still alive and kicking.

Roth IRA vs 401(k) – The Bottom Line

The Roth IRA and 401(k) are both tax-advantaged retirement savings plan with defined benefits and advantages. The good news is that you are not restricted to one type of saving to the exclusion of the other. You can contribute towards both, but you should do so strategically.

Between the Roth IRA and the 401(k), the choice of retirement saving plans is predicated on whether your employer matches your contributions or not. If they do, you should at least contribute enough to match that contribution. Assuming you make $100,000 and your employer matches 6% of your salary, you should at least contribute a minimum of $6,000. Having done that, you can then max out contributions to your Roth IRA to the tune of $6,000 which is the current limit for 2019. If you then want to invest more, you can go back to 401(k) and then invest as much as you can up to the $19,000 mark, which is the limit for 2019.

If however, your employer doesn’t match your contribution, you’ll want to max out your Roth IRA first with that $6,000 for 2019, and then you can contribute as much as you want into your 401(k). The reason for this is basic – the Roth IRA grows tax-free in addition to other benefits.

BA in Accountancy, he entered the entrepreneurial world by starting his first online marketing business in 2004. He is passionate about personal finance, self-development, the stock market, and a digital marketing addict. He strongly believes that financial knowledge combined with self-discipline is the key to achieving financial freedom.  He is also an avid golfer and a 15 handicapper.

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