401(k) vs Roth IRA: Which Retirement Account Should You Choose?

If you are trying to decide between a 401(k) vs Roth IRA for your retirement savings, first let me say congratulations.

According to the Fed's 2018 Report on the Economic Well-Being of U.S. Households, 25% of U.S. adults have no retirement savings. That stat is alarming considering that a recent study by Charles Schwab found that on average Americans believe they need to have $1.7 million to retire!

How much you will need to save will depend on your lifestyle in retirement, but chances are you would prefer to live out your golden years comfortably.

Start with 401(k) or Roth IRA?

I will get into details later, but for those just looking for a quick answer, here is a quick list to follow.

If your employer offers a 401(k) match, take full advantage of it. Each employer is different, but let's say that your employer will match 100% of your contribution up to 5% of your salary. This means if you make $100K a year, you should contribute $5K. In return, your company will also kick in $5K. That is free money and the best investment you can make.
If your employer does not offer a 401(k) match, start with a Roth IRA first. If your income is too high to qualify for a Roth IRA, then contribute to a traditional IRA. Either way, try to hit the maximum contribution allowed, which was $6,000 in 2019 ($7,000 for this 50 and older).

IRA, Roth IRA, Traditional 401(k), or Roth 401(k) - Which Ones do I need?

You may have heard that as you plan for retirement, you should consider both a 401(k) and an IRA. Sounds good right, but wait, what are the rules? No worries, I will cover the details on each of these accounts, as well as their benefits and limitations.

IRA

The Individual retirement account (IRA) is an excellent choice for people who have employers that do not offer a 401(k) or that are self-employed. There are two types of IRAs, Roth and Traditional. Each type has its specific advantages, but they both have the same annual limit. Individuals under 50 can contribute $6,000 a year, while those over 50 can put away an additional $1000. Opening up an IRA is as easy as reaching out to your favorite brokerage firm or bank. Most of them have online applications you can fill out to get started.

What is a Roth IRA?

Putting it simply, a Roth IRA is an individual retirement plan that allows using after-tax income to fund your IRA. What makes it a great option is that withdrawals from your IRA in retirement are tax-free. That is a significant benefit if you are concerned about being in a high tax rate in retirement.

There are caveats around Roth IRA, though. Here are the limits as of 2019. If you are earning $120,000 as an individual, you are not permitted to contribute the full amount into your Roth IRA account. And married couples who make more than $203,000 are not eligible to have a Roth IRA account. If you fall into one of these groups, a traditional IRA may be your best option.

What is a Traditional IRA?

Unlike a Roth IRA, a traditional IRA does not have income restrictions. You are free to contribute the allowed max per year regardless of your income bracket. Typically people will choose a traditional IRA if they make too much income, or if they prefer to get the tax break now versus retirement. Distributions from a Roth IRA get taxed as ordinary income in retirement.

401(k)

401(k) type of retirement account is an excellent option for people who have employers that offer this benefit. Employers make use of this type of retirement account to help their employees save for retirement. Similarly, there is the traditional 401(k) and Roth 401(k).

What is a Traditional 401(k)?

With the traditional 401(k) account, your employer will deduct a percentage of your salary and invest in options you select. Investment fund options will vary depending on the broker your company chooses, but generally, you should find suitable choices for your age and comfort level.

A traditional 401(k) has two main advantages. First, money that you contribute to a 401(k) is tax-free, and it lowers your taxable income. This means you get the benefit of saving for retirement and reducing your taxes now.

The second main advantage is the employer match. In general, most employers offer a company match as part of their benefits package, and that is free money for you. The percentage they will match varies, but hey its free money. So be sure to take advantage and contribute at least enough to get 100% of your employer's contribution.

What is a Roth 401(k)?

This type of retirement plan is also similar to the traditional 401(k) in various aspects except that the contributions made by employees are not tax-deferred. Hence, the income earned and withdrawn from a Roth 401(k) account is tax-free. It is worthy to point out the limitations that come with using a Roth 401(k). There is a limitation on the amount you can contribute, as an individual, based on your age. For instance, currently in 2019, $19,000 per year is the contribution limit for individuals who are using Roth 401(k).

Roth IRA or 401(k) - Wrapping Up

The biggest reason why you might want to consider Roth IRA over 401(k) is the tax-free withdrawal you can make. As explained earlier, the after-tax money deposited into Roth IRA accounts is tax-free when you withdraw it in retirement.

So if you are concerned about paying taxes when you retire, the Roth IRA is a good option. On the flip side, while you save on taxes with a 401(k) now, you will have to pay taxes distributions in retirement.

In reality, though, you should take advantage of the benefits of both a ROTH IRA and a 401(k). As stated in the quick answer above, start a 401(k) first and contribute enough to take advantage of the company match. Then if you have money left over, open a Roth IRA so you can also reap the benefits of those tax-free withdrawals in retirement. Having both accounts will give you the right blend of retirement income.

In conclusion, with the knowledge you have accrued here about the different retirement accounts, I hope you are enthusiastic about saving ahead for retirement. Do not be part of the 25% of Americans that are not doing any retirement planning. Take action now so that you can live a comfortable life in your golden years.