For many of us, retirement can often seem like something too far off in the future. However, as we approach retirement age, and as we are exposed with news of economic instability, we often wonder what is in store for us during retirement. Because of this, a question we often ask ourselves is: Where is the best place to invest to get the most for our retirement?
Although there are other choices available, the most popular are the traditional 401(k) and the Roth individual retirement account (IRA).
The traditional 401(k) is one of the oldest retirement plans available, which was introduced by Congress in 1978. Here, the employee is expected to give a contribution — from earnings that are pre-taxed (gross income) — that goes into their retirement plan, sometimes called deferred funds. These funds are then separately deposited by the employer into a different or special savings account which can be allocated in a variety of investment options up until the time employees are qualified to receive or collect their retirement money.
On the other hand, the Roth IRA is a relatively newer retirement plan wherein an individual can set aside post-tax (net) income up to a limited amount each year.
What Are The Main Differences?
For the Roth IRA in 2022, regardless of whether you are a single individual, or married individuals filing jointly or separately, may contribute up to $6000 each year, and $7000 for ages 50 and older. Keep in mind Roth IRA are individual retirement accounts. So, even though a couple is married they will have separate Roth IRAs.
For traditional 401(k) plans in 2022, contributors under 50 can contribute up to $20,500 each year, while a contribution of up to $27,000 can be made for those above 50 years old.
When someone contributes to their Roth IRA they are 100% vested. In other words, the person owns 100% of the money within the account. 401(k) vesting requirements are vastly different from the Roth IRA. Contributions to a 401(k) plan consist of employee deferrals and, if applicable, employer matching contributions. Like the Roth IRA, any contributions made by the individual (also known as deferred contributions) and the earnings on those contributions are always 100% vested. But, the employer matching contributions and the earnings on the employer contributions must vest under a schedule. The 401(k) vesting schedule must be at least as generous as the two- to six-year graduated or three-year cliff schedules.
The Roth IRA provides better control and management to your account compared to the traditional 401(k). Although both have a wide range of investment options, the Roth IRA allows you to choose the investment house you want to utilize; for the traditional 401(k), you will be locked in to your company’s management options. For the traditional 401(k), the default choice could oftentimes mean a poor choice. However, if the management option in your company is relatively good, then this shouldn’t be a problem.
Taxes remain one of the biggest differences between the traditional 401(k) and the Roth IRA. In a traditional 401(k), contributions lower your federal income taxes. For example, if you were to earn $50,000 per year and contributed $2000, you only have to pay income tax for $48,000. Once you reach the age of 59.5, you may opt to withdraw your funds however you will be asked to pay taxes on any money that is withdrawn. Also, since the government wants you to pay income tax at some point, you are now required to take minimum distributions from your 401(k) starting at age 72.
For the Roth IRA, for the same $2000 contribution, you pay the taxes upfront, instead of when you withdrawal funds. Remember, contributions to a Roth IRA are made with net income (post tax). However, since you pay taxes up front the government does not require any minimum distributions.
Another thing to keep in mind is that although the 401(k) employee contributions are not subject to income tax until they are distributed, employee and employer contributions are immediately subject to payroll taxes.
So … Which One To Choose?
There are advantages and disadvantages when it comes to choosing between a Roth IRA and traditional 401(k). For example, it makes sense to choose the traditional 401(k) when your employer offers a matching contribution because a 401(k) match is a 100% return on investment. Always take advantage of free money! Seriously, what other investment do you know that guarantees a 100% return?
Even if you don’t know what to invest in, most 401(k)s offer a cash account. Invest your funds into the cash account to take advantage of your employer matching contributions until you figure out your investment objectives. But, should you feel that taxes will be higher when it’s time to withdraw your funds, then a Roth IRA may make more sense.
Remember, there are plenty of reputable companies that can help you with your 401(k) retirement planning and related services.
Despite what any financial guru says, choosing between the two plans remains highly situational – unless you get a 401(k) match – so be sure to take into account your particular circumstances and only factual information when weighing your choice. After all, it is ultimately your money and your retirement that’s on the line.
About the Author: Dominique Brown was born in Philadelphia and is the owner of the Your Finances Simplified Academy.
Photo Credit: stock photo
There are some diversification advantages to owning both Traditional and Roth IRAs. None of us know our own futures let alone tax policy, etc. Having both IRA’s allows some flexibility in future withdrawals.
The correct answer generally is own both types of accounts if you meet the income criteria.
Earning interest on all that pretax 401k money is a big deal, especially once you’re into retirement. This is often overlooked and a huge advantage to the 401k.
Use a personal Roth account to fill in holes left by the 401k plan administrator. 401’s are notorious for having horrible choices on the more volatile but higher average return investments. If you need some small cap, short term bonds, want to do a little tilting or if your company has an index fund with completely overblown costs, put it here.
Don’t forget that your Roth investment (just the principle) can be withdrawn at any time penalty free. If you incur a catastrophic financial burden, having this kind of money available is nothing to sneeze at.
We’re probably stuck with 3-5% returns for the foreseeable future, and don’t be surprised when the social security bills aren’t getting paid and the calls for publicizing the individual retirement accounts start. Protect yourself and diversify.
Dominique Brown says
I agree with your point on the 401k having horrible options. But, even if you make the income requirements the decision should come down to what you believe your tax rate will be at retirement for the ROTH. If you’re in a high bracket now and think you will retire in a lower bracket the ROTH is a bad idea.. it might be best to go with a traditional IRA in this instance
That’s IF you believe that tax rates will stay the same. Since I don’t trust the gov’t to leave tax policy stable for the next 40 years, would prefer to hedge my bets and average out my liability. Could just as easily do this splitting between pre and post tax 401k contribution, but prefer having a different company handling some of my investment.
It’s just too powerful a tool not to have one set up. Throw spare cash into a Roth money market fund if you must. Now you have bankruptcy protected cash.
Dominique Brown says
I understand your tax rate argument. But what makes you think the government won’t change the rules on ROTH IRA’s?
I prefer to go the 401(k) but I can definitely see the benefits in both.
Dominique Brown says
I choose the 401k. I cannot invest in the Roth IRA due to not meeting the eligibility requirements. Also, those in high tax brackets or who think will have a high tax bracket at withdrawal time should think twice about investing in the Roth IRA.
This article glosses over the most important benefit of ROTH IRAs: zero taxes on investment appreciation.
401k: pre-tax contributions, both the principle and growth are taxed upon distribution
ROTH: after-tax contributions, NO TAXES on either the principle or growth upon distribution
There’s a reason ROTH contributions are off-limits to high-income earners, and it’s not because the government is protecting them from a bad investment choice. If you qualify for a ROTH and have decades of investment returns ahead of you, it’s a no-brainer.
Dominique Brown says
Todd I’m not too sure the ROTH is a no brainer in all circumstances despite gains being untaxed. For example a single person making 110k is in one of the highest tax brackets. If this person invests in the ROTH they will be taxed at that higher rate upfront. It’s quite possible when they retire they will be in a lower tax bracket. If I believed my tax bracket would go down at retirement I would choose the 401k over the Roth
I’m fortunate to get great matching in my work retirement plan (403b since I work at a uni), so I put the bulk of my money there. I’m considering stopping my optional/unmatched 403b contribution and putting it towards a Roth IRA instead – just to hedge my bets on the tax end of things.
My husband’s retirement situation is a bit dicey – he’s got an IL state pension plan, so we’re doing whatever we can JUST in case the state doesn’t figure out their pension fiscal woes by the time we retire. So far, all we have are Traditional IRAs setup (to offset a large tax bill last year), but depending on this year’s tax situation, that may change. I can’t wait for all the tax forms to come in so I can budget for taxes/investments!!
Len Penzo says
I can relate. I thought I was the only one who actually looked forward to getting my tax forms!
Why wouldn’t this article compare the differences between the Roth 401(k) and the Traditional 401(k)? There are huge difference between the Roth and Traditional 401(k), so this article was like comparing apples to oranges. In the comparison for this article the Traditional 401(k)wins hands down. Why?
Are payroll taxes the same thing as self-employment taxes? I can’t figure out any of this tax nonsense. Let’s have a flat tax.