by Minh Tran
The days that workers can count on their employers’ pension plan and Social Security to cover the costs when they retire are long gone. Nowadays, it is all up to YOU to set yourself up for the golden years that are retirement. Today we’ll introduce you to two of the most popular retirement plans, Roth IRA and 401(k), what they are, as well as their pros and cons.
The Roth IRA and 401(k) are both retirement investment accounts, however, there are significant differences between the two of them. To maximize your savings for retirement, you have to understand how each of them works. First, let’s discuss what they are and how to use them to your advantage.
401(K) 401(K) is offered by many employers and is the type of retirement saving plan that allows you to set aside a portion of your paycheck each month. You can choose to invest a percentage of your paycheck or a specific amount, it all depends on what you prefer. The key here is that the money you invest in this account would be pretax money, meaning that whatever amount you invest would be taken out of your income before that gets taxed.
Pros:
Employers match:Employers match means that for a 401(k) retirement plan, your employer would contribute to your retirement savings plan according to your own payment each year. With this, you will technically gain free money in your retirement savings that you could spend when you retire.
No income limit: There is no limit to how much you earn, you are always eligible for your employer’s 401(k). Pretax investment:Every dollar that you put into your retirement account will always be before it is taxed, this helps lower your income tax each year. Cons: Waiting period: Often, if you just joined a company, there will be a waiting period before you could join their 401(k) plan. You might have to pay more taxes: 401(k) can help you save money from income tax when you are still working. However, as soon as you retire, you will have to pay taxes as you withdraw money from your account. Furthermore, if you have a bigger income than when you are still working under 401(k), you might be taxed more since you’ll be placed in a higher tax bracket. Limited options for investment: in a 401(k) plan, you will have to follow whichever options that your company went with. Depending on their choices, there might be a very limited number of funds that you can choose. RMD (Required Minimum Distribution): With a 401(k) plan, you can’t leave your money untouched forever. Beginning at age 70 ½, you will have to start withdrawing money or there will be a penalty to your retirement account. There is also a penalty if you start withdrawing money at age 59 ½. That’s it for part 1. Next week we’ll talk about Roth IRA, how it differs from 401(k), as well as how to use it to your advantage.Unlike a 401(k), a Roth IRA is a type of retirement savings account that you can open by yourself. With a Roth IRA, however, the money that you contribute to your account would be after-tax money, meaning it won’t be able to save you from income tax. But wait, there is a catch! Your savings would be able to grow tax-free! There will also be no penalty if you want to withdraw your money at 59 ½ years old.
Pros:
No tax: Your Roth IRA account will not be taxed and will be able to grow freely since
you invested in your account with taxed money. You also don’t need to pay any taxes in
the event that you want to withdraw money from your account.
Independence: With a Roth IRA, you can set it up whenever you want, however you
want, without having to depend on an employer, as long as you make sure to contribute
the minimum amount each year.
More investment options: Another perk of being independent is that you can choose
any mutual fund that you want to invest in without being dictated to a limited number of
options by an employer.
No RMD: You can leave your money in your Roth IRA for as long as you want, without
any penalty after the age of 70 ½ . However, you would still be penalized if you make
any withdrawals before you reaching 59 ½
Cons:
Income limit: One disadvantage of Roth IRA is the amount that you can contribute
depends on how much you earn. If you earn less than $125,000 annually, you can
contribute the full amount to the retirement account, which is $6,000 or $7,000 if you are
older than 50. Make more than $125,000 and you would have to pay less and less until
you reach $140,000, in which case you won’t be able to contribute at all.
Less contribution limit than 401(k):
In a Roth IRA account, you can contribute up to
$6,000 a year, which is less than 30% of the maximum you can contribute in a 401(k)
account ($19,000 per year).
In Conclusion:
Both the Roth IRA and 401(k) are good options to invest in. As you can see from the
pros and cons of these accounts, they balance each other out quite well. If one has
limitations in one aspect, the other does it well and vice versa. If possible, the perfect
option would be to actually invest in both and enjoy the benefits that are the best of both
worlds. However, if you are unable to do that, we would advise speaking to a
professional who could help identify your ability to contribute, your needs, as well as
other factors including your employer, income, and state laws.
This article was written to serve as a primer that helps you familiarize yourself with the
different types of retirement accounts. We hope that it clears any confusion and
answers any questions that you have regarding this topic. Please comment below and
let us know if we missed anything as well as topics that you would like us to cover next!