401(k) vs. Roth IRA

Many people who start saving for retirement find it difficult to decide between two tax-advantaged savings accounts: 401(k)s and Roth IRAs. Both come with perks, so here are some key differentiating factors to help decide which option may be best for you.  

• Tax Considerations: Contributions to a 401(k) account are pre-tax, which means that you do not pay federal income tax on the contributions to a 401(k) account. However, the withdrawals upon retirement are taxed, so paying taxes just gets postponed until retirement age. Roth IRAs are just the opposite: you pay taxes prior to contributing to the account, and then withdrawals are tax-free upon retirement.  

• Employer matching: Partial or full contribution matching is a common feature of many employer 401(k) plans. In a partial match plan, employers match a portion of the employee’s contribution to a 401(k). For example, 50 cents for every dollar contributed to a 401(k) up to a maximum percentage of the employee’s income. Full matching means employers put in dollar-for-dollar what employees contribute which means for every dollar contributed by the employee, the employer also contributes a dollar thereby doubling the amount initially contributed to the 401(k) account.  

• Contribution Limits: Both 401(k) and Roth IRA contributions are limited by the Internal Revenue Service. The limits are subject to change, however, generally, the 401(k) has a significantly higher annual contribution limit than a Roth IRA, which means you can contribute more to a 401(k) per year without penalty.  

• Required Minimum Distributions: If you have a 401(k), you are required to start taking minimum distributions (RMDs) at a certain age. In other words, you can’t leave all your money in a 401(k) after you retire. Roth IRAs do not have a minimum distribution requirement. 

• Income Limitations: After you make a certain amount of income, you may no longer be eligible to contribute to a Roth IRA, whereas there are no income limitations on 401(k) contributions. 

Now that you know the main differences between each type of account, here are some tips to help you decide which one to utilize: 

1. Take advantage of employer matching. Begin by maximizing any matching your employer offers. This is by far the greatest feature of a 401(k), so contribute the maximum percentage your employer matches (whether full or partial matching) first so as not to leave free money on the table.  

2. Factor in your future income tax rates. If your employer doesn’t offer 401(k) matching, the next item to consider is whether your future income tax rate will be higher or lower. If you anticipate having a lower income tax rate in the future (which is common for most people), then a 401(k) may be a better option as you will delay paying taxes until you retire. 

3. Consider diversification. If you have additional income available to contribute toward retirement after contributing to a 401(k), you may want to consider contributing to a Roth IRA in addition to a 401(k). Roth IRAs are more flexible than 401(k) plans since contributions are post-tax. Early withdrawals can be made penalty-free, although the earnings may be taxed if withdrawn prior to retirement age.  

Regardless of which type of retirement account you decide to utilize, it is important to start saving for retirement as early as possible to give your money more time to grow, ideally contributing at least 10-15% of your income each year to a retirement fund. 

Happy saving!