401(k) vs. Roth IRA: Which One is Right for Me?

By now, you’ve likely heard the terms 401(k) and Roth IRA over and over again—whether from your parents, online finance bro, or your employer. But, what does it all really mean, and how are you supposed to know which one to invest in? In this guide, we’ll go over the fundamentals of both retirement savings accounts so you can make the most informed decision on which one best suits your future goals.

1. What is a 401(k)?

401(k) accounts are employer-sponsored retirement plans. To contribute to these types of retirement accounts, an employee designates a portion of each paycheck that automatically gets diverted into their 401(k) account. These contributions take place before income taxes and are automatically deducted from the employee’s paycheck.

Several different investment options vary from a 401(k) plan to a 401(k) plan and from provider to provider and employer to employer. 401(k) plans usually offer a combination of mutual funds and exchange-traded funds (ETFs). No matter which type of 401(k) you are enrolled in, investment gains are not taxed by the IRS until you withdraw them — compared to Roth IRA accounts, of which the qualified withdrawals are never taxed.

1.1. Contribution limits

The contribution limits for 401(k) accounts are significantly higher than those for Roth IRAs and are as follows for 2022:

  • $20,500 for workers under age 50.
  • $27,000 for workers age 50 and up—this includes an allowance for “catch-up” contributions of an additional $6,500.

1.2. Employer match

In general, the 401(k) is considered the most beneficial when employers offer a match, meaning they contribute additional money to the employee’s account. These matches are typically a percentage of the employee’s contribution, up to a certain percentage of their salary.

Some employers may match 50% of their employees’ contributions. What’s more, these matches do not count toward the employee’s contribution limit. However, the IRS does cap how much can go into a 401(k) annually, including the employee’s contributions and the employer match.

The 401(k) combined contribution limits for 2022 are:

  • $61,000 in total contributions for employees under 50 years old.
  • $67,500 for employees 50+ (this includes the previously discussed $6,500 catch-up contribution).
  • 100% of an employee’s annual earnings — if lower than the dollar amount maximum.

1.3. Taxes

Contributing to a 401(k) account comes with tax breaks and benefits. Employees can deduct their 401(k) contributions when they file their income taxes, which reduces their taxable income, saving them money.

Once you reach retirement age, you will start paying taxes and withdrawing from your 401(k) account. These withdrawals, known as distributions, are subject to income taxes at the tax rates upon withdrawals.

1.4. Required minimum distributions

People with 401(k) accounts must take required minimum distributions or RMDs. This refers to the minimum amount they have to withdraw every year from their 401(k) account in retirement. In a nutshell, you can’t leave all of your funds in your 401(k). If you do, you’ll be subject to a 50% tax penalty on the RMD that you did not withdraw. People with 401(k) accounts are required to start taking their RMDs by April 1 of the year after they turn 72 or the year they retire, whichever comes last.

2. Pros and cons: 401(k)

Now we’ll take a look at the most significant advantages and disadvantages of 401(k) plans.

2.1. Pros

  • Employer match.
  • Contribution limits are higher than Roth IRA accounts.
  • The account is maintained by the employer.

2.2. Cons

  • Fewer options for investments.
  • RMDs.
  • Fees are higher.

3. What is a Roth IRA?

Now that you know the basics of 401(k) accounts, let’s go over the fundamentals of Roth IRAs.

Roth IRA accounts are special individual retirement accounts where the contributor pays taxes on the money that goes into their Roth IRA account. The benefit of this is that all future withdrawals are tax-free.

Another major difference between Roth IRAs and 401(k)s is that employers are not involved in Roth IRAs. Instead, individuals set these retirement accounts up independently. This provides the added benefit of having more control over your investment options as you aren’t limited to just what your employer’s plan offers.

Another difference is that after-tax money funds Roth IRA accounts. Therefore, no tax deductions are available during the years contributions or deposits are made. Therefore, you don’t have to worry about your withdrawals during retirement being subject to income taxes. All investment gains are also untaxed while they stay in the Roth IRA account.

3.1. Contribution limits

Roth IRA contribution limits are much smaller. The maximum annual contribution for Roth IRA accounts in 2022 is as follows:

  • $6K for people under age 50.
  • $7K for people 50 or older including $1K catch-up contribution.

3.2. Income limits

How much you can contribute to your Roth IRA varies in part based on your annual earnings. If your income or filing status changes, the allowed contribution amount can be reduced or even phased out until elimination.

In 2022, people who file their taxes as single can make full contributions to their Roth IRA accounts if their income is less than $129,000. If income is between $129-144K, the contributions would be reduced or phased out. People earning more than $144K cannot make any contributions to a Roth IRA account. People who file their taxes jointly with a spouse can make full contributions to their Roth IRA accounts as long as their combined income is less than $204K. Couples with a combined income between $204K and $214K will have their contributions reduced or phased out.

3.3. Withdrawals

Roth IRA funds can be withdrawn at any age without taxes or penalties. But, withdrawals on earnings may be subject to income taxes and a 10% penalty—depending on the age of the contributor and their Roth IRA account.

Generally speaking, these fees can be avoided if you’ve had your Roth IRA account open for at least five years and you make the withdrawal:

  • After you turn 59 1/2.
  • After a permanent disability.
  • To buy, build, or renovate your first home (up to $10K).
  • After your death, a beneficiary or estate makes the withdrawal.

There are other qualified exceptions that would allow you to avoid the penalty, but not the tax, if the above requirements are not met.

Another difference between 401(k) accounts and Roth IRA accounts is that Roth IRAs have no RMDs. So, if you never end up needing the money in your account during retirement, you can simply leave it in there, and it will continue to grow tax-free.

4. Pros and Cons: Roth IRA

Now we’ll go over the most significant benefits and disadvantages of Roth IRA accounts.

4.1. Pros

  • Withdrawals made in retirement are tax-free.
  • There are more investment options.
  • No RMDs.

4.2. Cons

  • Lower limits on contributions.
  • Income limits that can prevent you from making contributions.
  • Employer match not provided.

5. Final thoughts

As you can tell by now, both 401(k) and Roth IRA accounts are retirement savings accounts with their own sets of tax advantages, investment options, and employer contribution options. The most important similarity between the two types of accounts is that both allow your money to grow tax-free, with the main difference being that 401(k) contributions are pre-tax. In contrast, there are no tax savings or deductions for Roth IRA contributions. But, Roth IRA contributions can be withdrawn tax-free once you retire.

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