When planning for the future, how does a 401(k) compare to a Roth IRA — and why are these plans so important?
Saving for retirement is one of the most common (and most important) reasons to start taking financial planning seriously. By maximizing the power of the stock market, and the mathematics of compound interest, AND the added encouragement of tax-free investment, it’s possible to turn a modest sum into a comfortable nest egg. But to do that, it helps to understand your options. Here’s an overview of some of the basics.
A 401(k) is a retirement plan sponsored by your employer that lets you contribute a portion of your wages into an investment account. Most employers offer matching contributions, so for up to a certain amount you chip in per paycheck, they’ll chip in extra money as well. Often, it’s dollar-for-dollar up to 3% of your paycheck, although 50 cents for every dollar up to 5% of your paycheck is also a common option. Find out if your company matches and how much, and take as much advantage of this free money as you can.
If you work for a non-taxed company, like a church, some non-profits, or a government entity like a public school, instead of a 401(k), you’ll have a similar option called a 403(b). The basic principle is the same: Your contributions go into an account and you can select from a menu of investment funds where that money will go. If, for example, you want a third of your contributions in small tech firms, and a third in industry-leading large corporations, and the final third divided between European companies and U.S. automakers, you might be able to do that (although details will vary depending on your company’s 401(k) offerings). As the stock market rises and falls, your account can rise and fall in value as well, so diversifying those investments is important, but in general, the choices are broad enough that money multiplies well above what a savings account would offer.
Where some of the biggest value comes in is in what these plans do to your income — at least as far as the IRS is concerned. Your contributions to your 401(k), which might start as soon as you start a job if your employer has automatic enrollment, are tax-free. In other words, when you fill out your annual tax forms, your taxable wages are that much lower, so the amount of taxes you owe every year is lower.
The interest that grows in your account is also tax-free until you start distributing the money, which usually happens in retirement. If you have to withdraw earlier in case of an unforeseen emergency, you can, but you’ll have to pay a substantial penalty in addition to the bigger tax bill.
There are limits on how much you can contribute to a 401(k) every year, and some plans cap the amount you can contribute once your salary rises past a certain level.
You’re also required, in retirement, to start withdrawing money in what’s called a Required Minimum Distribution, or RMD.
The plan might be provided through your employer, but if you change jobs, the money can move with you. You can maintain your old account or roll funds into a new retirement account — and a Roth IRA is one popular option for doing that.
Your Roth IRA
A Roth IRA (or Individual Retirement Account) is like a 401(k) in a lot of ways. They’re both considered savings accounts, both rely on investments, and both are considered “tax-advantaged.” The limits on how much you can contribute per year are similar. But there are a few differences.
For one thing, you open your own Roth IRA. Your employer typically has nothing to do with it. That means you have fewer limits on what you’re investing in, but you also don’t get those sweet matching contributions.
For another thing, Roth IRAs don’t lower your taxable wages. The contributions you make to a Roth IRA are taxed the same as they would be if you deposited them into a garden-variety savings account. The interest in your account is tax-free, and, unlike a 401(k), when you withdraw money in retirement, it’s NOT taxed like income. In fact, you can withdraw your contributions whenever you want without paying anything extra. If you withdraw the earnings on those contributions, however, you could wind up paying taxes as well as a 10% penalty.
Another difference: A Roth IRA has no RMDs. You can take the money or leave it … that is, if you don’t need it for your retirement, you can let it keep accumulating interest and leave it to your heirs as a healthy nest egg of their own.
There are all kinds of strategies for maximizing the benefits of a Roth IRA and a 401(k) together, especially if you’re able to max out the allowed contributions to one or the other in any given year. Consulting with a financial advisor can help you make the most of your options, and might introduce you to options you hadn’t previously considered to make the most of your money, now and for the future.
Schedule an appointment with us to review your plan options and to evaluate if you are on track for retirement.