Saturday, 19 October 2019

401k vs Roth IRA: Which Option Is Better To Invest?

What we are going to be talking about in this article today, is the difference between a 401k and a Roth IRA. And this is a very important topic and it's one of these lessons that you are not learning in school or learning anywhere else, and it's extremely important to understand the differences between these two different types of retirement accounts out there. The other thing I want to point out here as well as people often think that it's one or the other. You can either have a 401k or you can have a Roth IRA, and that is not the case and in fact, the best strategy, in most cases, is to be taking advantage of both a 401k and a Roth IRA.

Let's talk about the first difference between these two investment vehicles.

401k: Employer

A 401k is sponsored by your employer, you have to be employed in order to be eligible for a 401k. So, personally, since I am self-employed, my company is one person, so I don't have a retirement plan, and so I am not eligible to have a 401k unless I set one up for my company. The one thing here that is important to understand is it's not mandatory. It's optional whether or not you want to opt-in to that employer 401k. 

Roth IRA: Independent

The Roth IRA is independent, it's something you go out there and you set this thing up on your own, it has nothing to do with your employer and as long as you are within certain income limits, anybody out there can open up a Roth IRA.

401k: Limited To The Employer Plan

With a 401k, this is one of the biggest issues with them, is that you are limited to the employer plan and 401ks are not all created equally. There are some 401ks that are really good, they have great selections for ETFs or funds and they are low in expenses, and there are other 401ks out there that are full of high fee investments that are just not really a good pick for most people. And the issue is, if your employer offers a bad plan, you are pretty much stuck with choosing something from that plan.

Roth IRA: Any Firm, Any Investments

The benefit to a Roth IRA is that you can go through any firm or brokerage that offers them, and with a self-directed Roth IRA, you can put anything in there. like stocks, Vanguard 500 fund, whatever you want to put in there, you choose what goes into that retirement account and you are tax-sheltered with that investment.

401k: Pre-Tax

The other difference is with your contributions. When it comes to your 401k, you are putting away your pre-tax income. Before you have a chance to even touch that money. It comes out of your paycheck off of your pre-tax income. 

Roth IRA: Post-Tax

With a Roth IRA, you are putting away your post-tax income, and a lot of people say, well, that is a huge disadvantage, but it's actually not when you consider the tax implications of each of these two investment vehicles.

401k: Company Match

It's an incentive that some companies are offering and it's called a company match. We will go over an example of what that looks like in a little bit. But with a 401k, some employers out there offer a match to incentivize people to contribute towards their retirement savings. In my case, when I worked for that utility company, they would match my contributions, $0.50 out of $1, up to 6%. If I contributed 6% to my retirement, they would contribute 3%, but if I did anything more than that, they would contribute no more than 3% of my annual salary as a bonus. With the 401k, if your company offers a company match, you have this possibility here to take advantage of completely free money being offered by your employer.

Roth IRA: No Match

The downside to the Roth IRA, there is no match out there. The government's not going to match your money, no body's going to give you extra money to reward you for using the Roth IRA, so there are no incentives like that.

401k: No Income Limit

As far as the 401k goes, there are no income limits as far as how much money you are making. You could make $500,000 per year and still contribute to a 401k. 

Roth IRA: Single - $137,000, Married - $203,000.

With a Roth IRA, there are income limitations where you can't make more than this amount of money. And for single filers in 2019 that is $137,000, and for married that is $203,000. So if you make over that amount of money, you can't contribute to a Roth IRA.

401k: $19,000 - Each Year

With the 401k, for the update numbers for 2019, you can contribute up to $19,000 per year of your pre-tax income. 

Roth IRA: $6,000 Per Year / $7,000 Per Year, If You're 50 or Up

In what they call a catch-up period, where you can do more contributions per year. 

401k: Reduce Tax Income

Now let's talk about the interesting part here, which is the tax benefits here, with the 401k, there is a tax benefit because you are about to reduce your taxable income, and based on what tax bracket you fall into, it may be advantageous to contribute extra money into your 401k to push yourself down a different bracket. That is one of the games people play here with the 401k, is ramping up their contributions to fall under a certain tax bracket, to save money by falling into a different bracket entirely.

Roth IRA: No Tax Benefit

There are no tax benefits with the Roth IRA, but there is a major difference in how you are taxed with both of these investments. 

401k: Pay Tax Later On The Growth

With the 401k, you are paying taxes later on the growth of that money. So you don't pay taxes going in, but you pay taxes once you start to take money out of that account and redeem that money. 

Roth IRA: Tax Now, Free Growth

With the Roth IRA, you are paying taxes now, you are contributing with post-tax income, but as a result, your money is growing tax-free. And that can be a huge benefit, especially for young people, is having decades of growth and compounding within a Roth IRA, without ever having to pay taxes, as long as they wait until 59½ year old to begin withdrawing from that account.

401k: Early Withdrawal = tax + 10% (59½)

Another huge difference between these two accounts comes down to penalties if you decide to take money out of these accounts. If you dip into a 401k early, you are going to get a huge slap on the wrist and it's going to be painful. You are going to pay all of the taxes on all of those contributions plus a 10% penalty. So, it's not something I would ever recommend doing, cashing out a 401k early. I know people that have had to do this for one reason or another, and it results in a nasty tax bill at the end of the year. 

Roth IRA: Withdraw Contributions Tax + Penalty-Free

The advantage to the Roth IRA is that you can withdraw your contributions at any point in time since you already paid taxes on that money. And you don't have to pay any taxes or withdraw penalties because it's money that you've already paid taxes on. So that is one of the benefits to the Roth IRA, is that, if you put money in there and down the road you need that money, you can pull out your contributions any time. But if you pull out any of the money from the growth of the account, that is when you are going to pay taxes, plus that 10% penalty. So, in a nutshell, any money you put into your 401k, you pretty much can't take it out except for specific use cases. So if you do think you are going to need that money, don't put it in your 401k, maybe put it in your Roth IRA, that way it can grow and down the road, you can pull that money out and pull out your contributions without paying any kind of taxes or penalties.

Hedge Against Future Tax Hikes

Then finally, one of the biggest differences here, in my opinion with the 401k versus the Roth IRA, is that it's kind of a hedge against future tax hikes. So basically, the way tax laws are written right now, with the Roth IRA, since you've paid taxes already and you used taxable income, you are not going to pay taxes in the future. With the 401k, you haven't paid taxes on this, so down the road, you are going to pay taxes. And this comes down to a question of, do you think taxes are going to be higher in the future, the same, or lower? 

  • If you think taxes are going to be lower in the future, then a 401k probably makes more sense because you can take advantage of that lower future tax rate. 

  • If you think they are going to be the same, there is no real difference here.

  • But if you think that taxes might be higher, based on our debt and all of the different, the problems we have with Social Security,  personally, I believe taxes will be higher in the future.

You can hedge against future taxes by paying taxes now and not having to pay them later through the Roth IRA. Now yes, they could change these tax laws but, the way it stands right now, you can lock in a lower tax rate today by using a Roth IRA instead of going through a 401k.

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