HomeBudget401k vs Roth IRA: Retirement Plan Rumble

401k vs Roth IRA: Retirement Plan Rumble

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If you’re trying to decide which side to take in the 401k vs Roth IRA investment vehicle battle, we’ve got some advice. Take your ringside seats and LET’S GET READY TO RUMBLE with retirement savings. 

401k vs Roth IRA 

As in any fair fight, our opponents have some similarities: they’re two of the most popular options when it comes to saving for retirement and they both come with tax advantages. 

But which one is worth putting your money on? 

What is a 401k? 

In this corner, we have the powerful 401k. A 401k is an employer-sponsored retirement plan where a predetermined (by you) amount of your paycheck is automatically deducted from your paycheck to be contributed into your 401k account. 

Not only is the “automatically deducted” part awesome since it takes most of the effort out of the investing equation, but those contributions are pre-tax dollars, so they also reduce your taxable income and grow tax-deferred. 

You’ll pay income taxes on your withdrawals during retirement, and those distributions will be taxed at the tax rate of your income at that time. So, with a 401k, you’re not taxed during your high-earning years and may be at a lower tax rate when it’s time to pay taxes on the withdrawals. 

The strengths of a 401k

The 401k’s greatest strength lies in the employer contribution (but that depends on your benefit package.) Some employers offer to match employee contributions up to a percentage of the contribution and your salary—in that case, failing to contribute to a 401k (at least up to the employer match) is like throwing free money away. Don’t do that. 

Your contributions, plus the amount your employer matches, goes into your 401k account to be invested in long-term investment funds, like mutual funds, index funds, or target-date funds. You have some control over how your money is allocated and will be able to choose from several investment options, which makes diversification easier. 

401k contribution limits and withdrawal penalties

As of 2022, the annual contribution limit for a 401k was capped by the IRS at $20,500, or about $1,708 per month if you’re maxing it out, but if you’re 50 years old or over, you can make catch-up contributions to a total limit of $27,000.

Since a 401k is intended for retirement, there’s a 10% early withdrawal penalty for anyone younger than 59 and a half. So, not only would you pay the penalty, you’d also be paying the taxes on your earnings—that could have you down for the count pretty quickly. 

With a 401k, you have to start taking your required minimum distributions (RMDs) by April 1st on the year that you retire or the year following the year you turn 72, depending on which is later. If you leave all of your money in your 401k, you’ll pay a 50% tax penalty on the RMD amounts that weren’t withdrawn. 

What is a Roth IRA

And in this corner, we have the mighty Roth IRA. A Roth IRA is an individual retirement account that’s not dependent on an employer—almost anyone with earned income can open one, unless you make too much ($129,000 as an individual or $204,000 as a married couple who file together, as of 2022)  to qualify. If you earn too much, a backdoor IRA may be worth considering. 

If you’re a stay-at-home spouse without taxable income, you may still be able to contribute to a Roth IRA. Each spouse can contribute to their Roth IRA up to the current limit, but the total of the combined contributions can’t exceed the taxable compensation reported on your joint tax return. 

You can set up a Roth IRA fairly easily (online, even!) with most financial institutions or popular brokerage accounts. Once you’ve set up a Roth account, you can arrange for automatic deposits from your bank account. Much like a 401k, you can choose what types of funds to invest in, which helps with diversification and allows you to tailor your investment options to align with your personal tolerance for risk. 

The strengths of a Roth IRA

The true strength of Roth IRA accounts lies in the tax benefits. Your Roth IRA contributions are based on after-tax income so they won’t reduce your taxable income for the current year, but you won’t pay taxes on the profit from that investment and can withdraw your money tax-free at retirement—which means more retirement money to spend. 

The Roth IRA is particularly advantageous if you’re at a lower tax bracket now that you may be in the future (especially applicable to newer earners just starting out on their career path)—and if your investments do as well as you hope, you’ll be glad that you knocked out those taxes way-back-when instead of paying on all of that profit at retirement time! 

Another big benefit that makes the Roth IRA such a contender is that you can make penalty-free withdrawals of your contributions (what you invested, not what you earned) at any time. 

You can also make tax-free withdrawals on your earnings under certain conditions once you’ve had the Roth IRA for at least five years. Those conditions include being permanently disabled, using the funds as first-time homebuyers, if withdrawals are made by your estate or beneficiary after your death, or once you’ve reached 59 and a half years old. 

That flexibility makes it easier to bob and weave through life’s blows, but the best personal finance advice is to let your money continue to grow!

Roth IRA contribution limits and withdrawal penalties

The maximum Roth IRA contribution weighs in at $6,000 in 2022 (or your taxable compensation for the year if you made less than that.)  If you’re 50 or older, you can contribute $7,000 annually. 

Although you can withdraw your contributions at any age or time tax-free and without penalty, and can make qualified withdrawals on your earnings under certain conditions, non-qualified withdrawals could result in income taxes and a 10% penalty. 

Unlike 401ks, there are no RMDs with a Roth IRA, so if you don’t need the money (wouldn’t that be nice?), it can continue to grow in the account to be used by your beneficiaries. 

The 401k vs Roth IRA battle breakdown

So here’s the blow-by-blow of the strengths we’ve covered so far: 

The 401k:

Possibility of an employer match

Higher contribution limits

No income limits

Managed by your employer

Contributions reduce your taxable income for the year

The Roth IRA:

Allows penalty-free withdrawals of your contributions

Withdrawals are tax-free in retirement 

Allows qualified withdrawals of your earnings prior to retirement

No RMDs

Not tied to an employer

Easy and affordable to set up independently 

Ding, ding, ding 

And the winner is…well, that’s up to you, your financial advisor, and your personal circumstances. Both types of accounts are strong investment choices for retirement and if you can manage it, having both a 401k and a Roth IRA is a sound strategy. Invest in your 401k up to the employer matching limit, max out your Roth IRA, and put additional funds towards your 401k’s contribution limit to maximize the advantages of each. 

No matter which side of the 401k vs Roth IRA battle you choose, you’ll be using the magic of compound interest to pave the way for a more secure future—and that’s a win all around. 

Ready to get serious about saving? Try YNAB for free for 34 days to create a budget and change your money mindset. 

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