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Roth IRA Vs 401(k) – Understanding the Key Differences

When saving for retirement, knowing the differences between a Roth IRA and a 401(k) can help you make the right choice. While both accounts offer tax advantages, the rules surrounding when you can withdraw and how much you pay in taxes differ significantly. This infographic will highlight some of the critical differences.

Taxes

While 401(k)s and Roth IRAs both help you save for retirement, they do so in different ways. The rules about how much you can contribute, when you must start withdrawing, and the investment options vary for each account type. Understanding the differences between Roth IRA vs 401k can help determine which accounts make sense for your retirement savings strategy.

A 401(k) is an employer-sponsored plan that allows you to assign a portion of your paycheck (pre-taxed) for automatic contribution into a curated list of investments. Typically, the employer will match your contributions. This can significantly increase your overall savings. However, 401(k) withdrawals are taxed as ordinary income at your current income tax rate in retirement.

Unlike a 401(k), a Roth IRA is funded with after-tax dollars. You can’t get a tax deduction in the year you contribute, but your retirement earnings and distributions are tax-free.

Generally, an IRA is more flexible regarding investment options than a 401(k). You can access a larger pool of investments and bargain-shop for low-cost mutual funds and ETFs. The only drawback is that you must take the required minimum distributions (RMDs) at age 70.5 or if you leave your job. To avoid the 10% penalty, you must begin RMDs by April 1 of the year following your retirement.

Flexibility

In general, IRAs are more flexible than 401(k)s. For example, if you change jobs or retire, you can move your IRA money to another institution (as long as the IRA provider is an approved custodian). You can also open a Roth IRA anytime and choose from thousands of investment options, unlike a 401(k) plan, which may only offer company-sponsored funds.

On the other hand, if you want to take advantage of your employer’s match in a 401(k) and have the ease of having contributions automatically deducted from each paycheck, a 401(k) can take a lot of work to beat. It’s often wise to have both, however, because you can’t predict what tax rates will be in the future or how your health or the stock market will behave.

It’s a big decision to determine precisely how to save for retirement. Still, by understanding the critical differences between a Roth IRA and a 401(k), you can make a better choice that suits your needs. It’s always a good idea to consult a financial professional when making these decisions. But if you do, they’ll likely suggest saving into a Roth IRA and a corresponding 401(k). They’ll know your situation, tax rate, savings goals, and more to help you decide which type of account best suits your circumstances.

Withdrawals

The Roth can make more sense than a traditional account, depending on your situation. It is beneficial if you expect to be in a higher tax bracket in retirement.

But you need to understand withdrawal rules to benefit from a Roth most. Knowing if you can withdraw your contributions without incurring taxes or penalties is essential. Knowing if you can start your account growth (within certain limits) is also helpful.

Withdrawals from Roth IRAs are made tax-free if they meet specific conditions. However, a five-year rule can apply if your withdrawals include converted assets or if you’ve withdrawn your contribution dollars before fulfilling the requirements. This rule can impact when you take a distribution, and it’s essential to understand it before investing.

Roth IRA withdrawals can be used to pay unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI). They can also be used to pay for qualified educational expenses of the account holder or their spouse or children. This includes tuition, fees, books, supplies, and equipment. They can also be used to pay for a first home. If you’re self-employed, you can also use distributions from a Roth IRA to buy a small business or to invest in startup costs. It’s best to speak with a financial advisor about your situation before deciding which account type to choose.

Investment options

Choosing between Roth IRAs and 401(k)s isn’t one-size-fits-all. It depends on your retirement goals and the assets you’re saving in each account. For example, some people prefer to save up for retirement using a 401(k) account, taking advantage of the employer match if possible. Others prefer the flexibility of a Roth IRA. They may want to invest in a more diverse set of funds or pay lower fees on their investments (which can be done through robo-advisors). Heirs who may receive distributions from the account after your death could also benefit from the tax-free status of Roth IRA accounts.

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In addition, if you prioritize your 401(k) plan to maximize the company match but have excess retirement savings you can’t put into that account because of contribution limits, consider opening a separate Roth IRA. This gives you more flexibility to invest your money however you like, and you can also find financial institutions that charge minimal or no fees at all. As a bonus, you can roll your 401(k) funds to a Roth IRA later in life. This is especially useful if you want to avoid taking required minimum distributions (RMDs) at age 70.5 since they’ll be subject to taxes and penalties unless you meet certain hardship exceptions. However, you should consult a financial professional before making any such decision.

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