Which is better, 401k or Roth IRA?
If you are considering opening a 401(k) or Roth IRA, you should understand how they compare, their pros and cons. Here is everything you need to know.
When saving for retirement, you have several options as to where to put your money. A 401(k) and Roth IRA are the most popular types of retirement savings accounts you can consider. A 401(k) is offered by an employer, and new employees are automatically enrolled into the plan either immediately or after sometime. On the other hand, a Roth IRA is not tied to an employer, and you can open an account with a brokerage.
A Roth IRA is a more preferred option for investors looking for greater flexibility in their retirement savings. If you expect your income or marginal tax rate to be higher in retirement, you can open a Roth IRA so that you pay your taxes now, and take tax-free distributions in retirement. Also, a Roth IRA has a wider pool of investments than a 401(k), and you can create a diversified portfolio across different types of investments. However, if you are looking to collect an employer match, having a 401(k) can help you maximize your contributions. You can decide to have both retirement accounts i.e. Roth IRA and 401(k), to enjoy the benefits of both worlds.
What is a 401(k)?
A 401(k) account is one of the most popular retirement savings plans in the United States, and it allows employees to invest a specific portion of their paycheck every month. The contributions to a 401(k) are tax-deferred, and this means that the contributions are not taxed, but you will owe taxes when you withdraw money from the 401(k) account.
Pros of 401(k)
With a 401(k), you can contribute as an employee up to the IRS contribution limit of $19,500 in 2021. You can also contribute an extra $6,500 in catch-up contributions if you are 50 or older.
If your company offers a match, the employer can contribute an additional "free money" to your 401(k) account. The employer's match does not count towards the IRS contribution limit, but the total contribution (employee and employer contribution) cannot exceed $58,000 in 2021, or $64,500 if you are 50 or older.
If you leave your employer, you can rollover the 401(k) to a Roth IRA, Solo 401(k), or other types of retirement account. A direct rollover has no tax implications, and you can rollover to a Roth IRA to enjoy a broader pool of investment options and tax-free withdrawals.
When you contribute to a 401(k), you get a tax break on your taxable income. This minimizes your tax liability, since you only pay taxes on the portion of income that remains after contributing to a 401(k) account.
Cons of 401(k)
Required minimum distributions
A 401(k) requires retirement savers to start taking RMDs when they reach age 72. If you fail to take the RMD, the IRS could impose a 50% penalty on the distribution you were required to take.
Fewer investment options
The investment options available in a 401(k) depend on the investments provided by the plan sponsor. Most 401(k) plans allow investors to invest in a small pool of mutual funds, stocks, bonds, and exchange-traded funds.
401(k) plans charge fees to investors for managing the investments on their behalf. 401(k) fees can range from 0.35% to 2.5% of the retirement assets. These fees can build up and eat away the returns earned in the 401(k).
A Roth IRA is a retirement savings account that you can open with an investment firm or brokerage. If your employer does not have a 401(k) plan, or you are self-employed, you can open an IRA account to start soaking away money for your retirement. Unlike a 401(k), you pay taxes when you contribute to a Roth IRA. However, when you take a distribution in retirement, you won't owe any taxes on the amount withdrawn.
Pros of Roth IRA
A Roth IRA does not require retirement savers to take RMDs. Once you reach age 72, you can let your money continue growing tax-free until when you need the money. There are no penalties for not taking the mandatory distributions.
A broader range of investment options
A Roth IRA offers a more hands-off approach to investing by allowing investors to choose their preferred investments from a wider pool of investment options. You can decide to invest in stocks, mutual funds, bonds, real estate, ETFs, etc.
When you open a Roth IRA, you pay income taxes when you contribute to the account. However, when you take distributions in retirement, you won’t pay any taxes. This means you will get your distributions in full, and you won’t have to worry about taxes eating into your retirement income.
If one couple is working and the other couple is unemployed, the working couple can contribute to a Spousal IRA that is the name of the other spouse. This allows the couple to double their annual contributions even though only one couple is working.
Cons of Roth IRA
Lower contribution limits
A Roth IRA allows account holders to contribute up to a maximum limit of $6,000 in 2021, or $7,000 if you are above 50. This is a lot less than the 401(k) limit of $19,500 in 2021.
If you are a single-member household, your modified adjusted gross income (MAGI) must be lower than $125,000 to contribute up to the maximum limit to a Roth IRA. For a married couple filing jointly, the MAGI must be less than $198,000.
401(k) vs. Roth IRA: Which is Better?
Generally, a Roth IRA offers a flexible investment environment for investors looking to create a diversified portfolio comprising different types of investments such as stocks, ETFs, mutual funds, etc. A Roth IRA is especially a good option if you think your retirement income will push you to a higher tax bracket, hence more taxes. While the lower contribution limit may be a deterrent for most investors, you can rollover old 401(k)s into the Roth IRA to spread the accumulated retirement savings across different investments and enjoy tax-free withdrawals in retirement.
If you want to enjoy the benefits of both worlds, you can have a 401(k) and a Roth IRA at the same time. This is especially a good strategy if you want to collect a match from your employer, and to accumulate more money in the retirement account. You can contribute to the 401(k) up to the IRS limit, and still receive an employer’s match up to $58,000 in 2021, or 64, 500 if you are 50 or older. You can then fund the Roth IRA up to the annual IRS limit.