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401(k) Vs. Roth IRA

November 09, 2021

Investing in a 401(k) Vs. a Roth IRA

When it comes to saving for retirement, you've got a ton of options. Two of the most popular are 401k's and Roth IRA's. In today's blog we're going to get into the nitty-gritty details of both of them. We'll talk about what might be right for you when saving for retirement.

The 401(k)

Now let's start with the 401. 401(k)'s are one of the most common investment vehicles when it comes to saving for retirement. For an employee of a for profit company it has been the retirement plan of choice for a number of years. Contributions go directly from your paycheck into your account, and if you use the traditional option they do that pre-tax. So you won't be taxed on it when it goes in, and from there it will grow tax deferred. That tax deferral means you're not taxed as it's earning money and grows over time. You will be taxed on the funds in the future, once you've reached retirement age and you draw the money out of the account. As a result of these plans being so popular, and having been around for quite some time there are lots of folks who have big balances in their 401(k)'s. Another advantage to 401(k)'s: company matches. A lot of times a company will put in money for you. The way a match works is this: you might put in 6% of your pay and they may match you 50 cents on the dollar, or put in another 3%. That's free money. Some companies will match you dollar for dollar up to 6%. In that example you can get 6% of your pay going into the 401(k); going into your retirement account for free! That's a huge benefit, so make sure you check to see if your company offers a 401(k) match and make sure you're taking full advantage of it. Yet another positive to 401(k)'s is that they have very large contribution limits. You can sock a lot of money away into a plan. This year in 2021, $19,500 can go in from you plus the company match. And if you're over the age of 50, you get a catch-up contribution, so you can put in an additional $6,500, which would take you all the way to $26,000 going into the 401k. Starting in 2022 that amount moves up another $1,000 so you will be able to put in $20,500 if under 50, and $27,000 if you are over 50 per year. There is certainly more to consider about a 401(k) but you now get the basics. Money goes in typically pre-tax, grows tax deferred, and is taxed upon distribution. Your company may give you free money via a match if you participate, and you can certainly put in a large amount of your own funds each year.

The Roth IRA

Let's flip over now and talk about the Roth IRA. How does that work? Well from a tax standpoint, it's the opposite of the 401(k). Money goes into the Roth post-tax, meaning you don't get a deduction when the money goes into the account. So it starts with income you earn, and after it has been taxed you can make a contribution into the Roth. Making that contribution will not result in any sort of deduction to your income for the year. So right off the bat this sounds like a much worse deal..... but wait! There's more! The big advantage the Roth has over a Traditional IRA or 401(k) is that once that money goes into the Roth, it's not subject to tax. Not only are your contributions not subject to future taxes but any money that the account earns as your balance grows over the years is not subject to tax as well. Now there are parameters to this - it has to have lived in the account for a certain period of time, or you need to be of retirement age. But it's a retirement account, so that's a perfectly fair limitation. What happens with using a Roth IRA is that as a result of the taxation is that it becomes a potential source of tax-free income or an asset in retirement. While you don't get the benefit upfront like with the 401(k), you get the benefit down the road of tax free retirement money. If you've got a very long timeframe in saving for retirement, that can be a huge benefit because of all of those deferred gains over all of the years that you're not going to pay taxes on if you've protected that money inside of a Roth IRA. As far as downsides to Roth IRAs: you can't put as much money in as in a 401(k). $6,000 can go in per year. If you're over the age of 50, you can put another thousand in, you can get $7,000 a year. That's a far cry from the $26,000 that can go into a 401(k) this year. The second downside, there are income limitations. If you make too much money, you're not allowed to put money into a Roth. This year 2021 that cap is $208,000 for a married couple filing joint. If your modified adjusted gross income is north of $208,000 - no Roth for you! You can't put money into it. There's a phase out before that, that will limit your contribution. But if you're north of that, can't put anything in at all. In 2022 that top line is moving to $214,000 for a married couple filing jointly. So there are some limitations to the Roth IRA option, although it can be a great benefit having that tax-Free retirement money building up for you over time.

Which One Should I Use?

A question I've heard a time or two is: Should I use a Roth or a 401(k)? Generally speaking, the lower your income, the lower your taxes, the greater benefit you have from contributing to a Roth. The reason is that the deduction that you're going to get from contributing to a 401(k) is less because you are in a lower tax bracket to begin with. If that's the case than giving up that small deduction to protect the account from future taxes can be a great benefit. If you're in a really high income tax bracket, you're getting a huge deduction when you're putting money into a 401(k) or a traditional IRA. If your income's a little bit lower and you're in one of the lower tax brackets you're not getting that much of a benefit when you're putting money into those vehicles. If that's the case for you it might make sense to choose the Roth over the 401(k). That being said - a major caveat is that if you are getting a substantial company match on the 401(k) - don't miss out on the match! If your employer offers a dollar for dollar match to your contributions you essentially have doubled your money the second it goes in! That's way too great of a benefit to forego. You can always check to see if your 401(k) plan offers a Roth contribution option. If it does that can be a way to have your cake and eat it too. Put your money in post-tax if your income is a little lower, but also get the free company match money from your employer.

The moral of the story here is that no matter where you put it, you need to save for retirement! Hopefully the post has given you a few things to consider when making the decision of exactly where you will save. If you've got questions about Roth's and 401(k)'s feel free to reach out. Thanks for reading! See you next time.

Distributions from traditional IRA’s and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS tax penalty.

To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.

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