It takes both discipline and a sound strategy to successfully plan for retirement, and having the proper investment and savings account can go a long way toward making sure you’re fully prepared. The Roth IRA and 401(k) models are two of the most common methods toward setting aside money for retirement, and watching it grow with tax-deferred benefits that will be there for you when you need it most.
Which one is appropriate for you will depend on your occupation and goals, and how you choose to manage your money both now and in the long run. By knowing how these two plans differ from one another and what they have to offer, you’ll be better positioned to make the very most of your individual savings and retirement account.
What is a 401(k)?
Deriving its name from the IRS tax code that created them and outlines how they operate, a 401(k) is an employer based retirement savings account that is available in two separate forms and offers tax benefits to those who pay into them over time. A 401(k) is usually the best choice for those who are employed by the government such as teachers or law enforcement officers, or anyone who has the opportunity through their employer.
Those who cannot invest in a 401(k) are the unemployed or anyone who doesn’t have this option through their workplace or employer. Two main forms of 401(k) plans exist – the traditional 401(k) and the Roth 401(k), which primarily differ in the way in which they are taxed.
What are the Tax Benefits of a 401(k)?
With a traditional 401(k), employees typically make tax-free contributions into their savings account through automatic withholdings of a portion of their income, which may or may not be met by additional contributions from their employer as part of their benefits. These contributions remain tax-free up until the moment they are withdrawn.
This differs from the way Roth 401(k)s operate, which may allow an individual to make withdrawals tax-free. Making contributions to a 401(k) plan can be a good way to prepare for the future while at the same time reducing your amount of taxable income in the here and now. Be sure to take the time to assess your strategy from multiple points of view, possibly sitting down with a licensed and qualified financial advisor who can outline a strategy and provide insights that may not be clear at the outset.
What is the Difference Between a 401(k) and a Roth 401(k)?
It’s important to have a working knowledge of the primary differences between a traditional and Roth 401(k) so you can understand which one will benefit you the most and how to make the most of it.
Both of these plans are similar in that they allow employees to defer money from their paychecks into a retirement savings account with the same contribution limitations, and both could receive contributions by the employer as well. The main difference between these plans is the way in which they are taxed.
While a Roth IRA is a post-tax retirement savings account, meaning that any contributions are already taxed prior to entering the account, traditional IRAs are a pretax account that is not taxed until the money is withdrawn. The major benefit of a Roth savings account is that any growth it experiences over time is 100% tax-free (except for employer contributions), whereas because traditional 401(k)s are pretax savings accounts rather than post-tax, any growth they attain up until retirement is taxed upon withdrawal.
What is a Roth IRA?
Those searching for a retirement savings plan with a greater degree of flexibility may enjoy the benefits of a Roth IRA. One difference Difference between a Roth IRA and a 401(k) is that contributions made to a Roth IRA are not tax-deductible, and any money placed into a Roth IRA may be withdrawn from the account at any time without incurring a fee or penalty from the IRS.
Some feel this allows for more freedom in how an individual can manage their savings in order to plan for retirement, without the added worry of hefty charges simply from moving savings from the account to somewhere else.
This makes a Roth IRA a good option for those who may need access to their money earlier than expected, or who simply desire the tax-free withdrawal an Roth IRA provides on the money it accumulates over time.
Roth IRA Limitations
While a Roth IRA can seem more flexible than other varieties of retirement savings accounts, there are still certain restrictions and Imitations that apply. For example, a Roth IRA has an annual contribution limit of $5,500, but this number is increased to $6,500 for those over the age of 50 (called the “catch up” limit).
It’s also important to remember that a Roth IRA is not offered through an employer, so it will have to be set up and managed by the individual themselves if they wish to use it as an option to save for their retirement. Converting a traditional IRA to a Roth IRA may make sense for those seeking the benefits of a post-tax retirement savings account.
Roth IRA vs. 401(k)
In the end, which plan you decide on will depend on your employment situation as well as how you intend to structure your retirement. Those looking to enjoy tax-free withdrawals when their retirement rolls around may lean toward a Roth IRA savings account, while others looking to reduce their taxable income immediately may find that a 401(k) is more suitable if it is available.
Seeking guidance from a qualified financial advisor may help to clear away any questions an individual may have or help them make any necessary adjustments along the way. Overall, all of these plans have unique features that can help those saving for retirement create a considerable nest egg savings that will be there for them when they need it most. Starting out with a Vanguard Roth IRA may prove to be a good starting point, being sure to make changes as needed to get the most from what these retirement savings accounts have to offer.