roth ira vs 401k

Roth IRA vs. 401K: Which one is better?

One of the many retirement questions that people ask is Roth IRA vs. 401K, which one is better? I believe that if you can do both then do it. The major difference between the Roth IRA and the 401K is the Roth IRA is an after tax investment and the 401K is a pre-tax investment.  If you work and your employer provides a 401K and matches your contribution, then you would be a fool not to participate because that’s like leaving money on the table.  You should contribute exactly what your company matches.  If the company matches 8%, then contribute 8% of your pre-tax income to the 401K.  Just remember.  It’s a pre-tax investment, which means you will pay taxes on it when you begin to draw down on it.  (That’s the catch!)  And if you withdraw before you turn 59 1/2 then you will also incur a penalty.

Because the Roth IRA is an after tax plan, then you don’t pay taxes on it once you withdraw. That’s a good thing. There used to be a time when company’s would payout big pensions.  People relied on company pensions and social security to get them through retirement. But today pensions have basically disappeared.  Just 30 years ago companies began to offer 401k’s.  They came about because high salaried employees were looking for a tax break and the government allowed companies to offer this method of saving as a tax break only if they would give it to all employees.  The change in the tax code was called section 401b and thus came the name 401K.  It wasn’t even meant for every day people like you and me.

What is Roth IRA?

Roth IRA is the newest kid on the retirement plans block.

It is self-directed, which means you can independently set it up through an investment firm. The steps in setting up Roth IRA are simple. You can simply contact an online broker, choose an investment option with them, and start depositing your after-tax money from your account into the Roth IRA.

When you reach 59 1/2 years old or older, you can withdraw both of your deposit and investment gains tax-free, provided that you’ve kept your plan active for 5 years.

How much can you contribute with Roth IRA?

The contribution for Roth IRA will depend on your income limit. This means that you must have an “earned income” in the year you want to make a contribution.

In 2018, the contribution for individuals under 50 years old is $5,000 while the contribution for 2019 is $6,000. Individuals who are older than 50 years may contribute up to $7,000 this year. This is the maximum contribution that you can contribute within one year.

What are the benefits of Roth IRA?

The largest benefit of Roth IRA is its tax-free withdrawals. Since you’ve contributed your after-tax fund, you can withdraw your funds before you retire without incurring penalty.

Another advantage of Roth IRA is more flexibility. Since it is self-directed, it offers more investment opportunities. That includes stocks, bonds, gold, real estate, and more.

In a 401K retirement plan, your investment choices are often limited by your employer depending on how much you earn. Also while you can take out a loan from your 401K savings plan, you will be bombarded with penalties when you withdraw before reaching the retirement age.  Plus it’s not easy to take out a loan, you have to declare a financial hardship.

What’s Good with 401Ks?

A 401K is an employer-sponsored plan. In a nutshell. First, you will have to sign up for an investment plan in your workplace and choose an investment option within the plan. Then, your employer will take out money from your salary before taxes are taken and deposit it into your plan.

In 2018, the maximum annual contribution for a 401K is $18,000 for individuals who are under 50 years old and $24, 500 for over 50 years old. This year, you may contribute up to $19,000 if you’re less than 50 years old and $15, 000 if over 50 years old.

In most cases, employers offer a matching fund where they match up to 5% of your contribution and you can get 100% return of your money.

What are the benefits of 401K?

The biggest benefit of a 401K retirement plan is the company matching program (That is IF your company provides matching). It means that your employer will contribute a certain amount of cash into your plan after you reach a specific savings limit.

For example, your employer may match a portion of your contribution up to the first 5% of your savings. So even if it has limited investment opportunities, you can still get a return of your money – and that is 100% guaranteed!

Also your employer’s contribution will not affect your annual contribution limit as it is treated separately. In fact, you won’t feel you’re paying for your retirement plan at all because your contribution is directly taken out of your paycheck.

Roth IRA vs. 401K: The smartest answer!

Ideally, you can max out both retirement plans. So if you ask me again, Roth IRA vs. 401K – which one is better? My answer is still the same….do both!

Like I previously stated, if your employer offers a 401K match, contribute enough to earn a full match. Next, contribute as much as you are allowed to Roth IRA. Your participation in 401K will not affect your eligibility to contribute to Roth IRA but you’ll have to check your income. The biggest question you’ll face now is this – can you afford to max out both retirement plans?

After maxing out your Roth IRA, return to your 401K retirement plan. The money you contribute to the 401K is deductible from your taxable income, so you still have enough money left for yourself.

But what if your company doesn’t offer a matching fund program? Then start with Roth IRA and have more control over your investment options.

Roth IRA vs. 401K: Conclusion

In many cases, Roth IRA is superior investment vehicle to a 401K because it gives you more freedom to control your investment.

However, if your company offers a full 401K match program do not bypass the opportunity to get free money by investing on it first before putting your money to Roth IRA.

Again your financial situation will greatly affect your decision. When you plan to max out both plans, try to consider these questions:

Is my income enough to sustain my contribution to both retirement plans before reaching the retirement age? If yes, then go for both plans. If not, then choose only one plan for now.

Do I expect my income to increase in the future? If yes, then you will most likely find yourself in a higher tax bracket which favors Roth IRA. If not, then you’ll probably stay in the same bracket as you are now which favors 401K.

Are you afraid to invest in either of these retirement plans? Well, think of this… your savings will not have the opportunity to grow as much as it can when you invest it. So contributing to at least one retirement plan is crucial if you ever hope to retire and get something out of your hard earned money.


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