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 IRA.
The traditional 401(k) is one of the oldest retirement plans available, which was introduced by the American Congress in the year 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, which was brought to formality only recently in 1998, is a retirement plan classification wherein an individual can set aside post-tax (net) income up to a specified or limited amount per year.
What Are The Main Differences?
Contributions
For the Roth IRA in 2015, single individuals may currently contribute up to $5,000 each year, and $6,000 for ages 50 and older. While married couples who are filing jointly may contribute up to $5,500, or $6,500 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 2015, contributors under 50 can contribute up to $18,000 each year, while a contribution of up to $24,000 can be made for those above 50 years old. The difference between the contribution amounts between the two requirement accounts is rather large.
Vesting
When someone contributes to their Roth IRA they are 100 percent vested. In other words, the person owns 100 percent 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 percent 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.
Investment Options
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. One other thing to note is that most 401(k) plans currently do not have ETFs as an investment option. There are some benefits to using ETFs over mutual funds.
Taxes
Taxes remain one of the biggest differences between the traditional 401k 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 $2,000, 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 required to take minimum distributions from your 401(k) starting at age 70.5.
For the Roth IRA, for the same $2,000 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.
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 percent return on investment. Always take advantage of FREE MONEY! Seriously, what other investment do you know that guarantees a 100 percent 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 401k retirement planning and related services.
Despite what any financial guru says, choosing between the two plans remains highly situational (unless you get a 401k 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 is owner and author of Your Finances Simplified. He was born and raised in west Philadelphia and is now a financial adviser, IT contractor, landlord, and treasurer of a non-profit.
Photo Credit: o5com
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.
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 25% bracket now and think you will retire at 15% 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.
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.
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 withdraw time should think twice about investing in the ROTH IRA
“For the Roth IRA, single individuals earning at least $110,000 may currently contribute up to $5,000 each year”
Whaaat? According to the IRS…
If You Have Taxable Compensation and Your Filing Status Is single with earnings less than $107,000, you can contribute up to the limit.
Which is the misprint?
Kcli,
My post is using the update 2012 rules.
Kcli,
Here is the link to the actual publication on the IRS website. IRS Publication 590.
http://www.irs.gov/publications/p590/ch02.html#en_US_2011_publink1000253532
It details the 2012 changes
Kcli is pointing out the error “at least $110,000” – the article should read single individuals earning “up to $110,000.” Single individuals making at least $110,000 but less than $125,000 have their Roth IRA contribution limit reduced (phased out) according to the IRS link above.
Gotcha.. When she mentioned the 107,000 that was indicative to the 2011 ruling. good catch on my error by saying “at least”
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.
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 the 28% tax bracket. If this person invests in the ROTH they will be taxed 28% 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!!
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? because one can contribute $17,000 to the 401(k) compared to the $5,000 in the Roth, AND there is most often a company contribution match with the Traditional.
Are payroll taxes the same thing as self-employment taxes? I can’t figure out any of this tax nonsense. Lets have flat tax.