Difference Between 401(K) vs Roth IRA
Can you think of the tax-saving vehicles available for employees so that they can save on taxes? Well, let me give you a hint. Based on the point in time that the people want a tax to be deducted from a portion of their savings. I am positive that you might have come across two such vehicles: 401(K) vs Roth IRA.
401(K) is a deferred income plan offered by the employer. While contributing for 401(K), an employee assigns an amount to be paid towards this plan. The income channelized for this plan is before taxes are deducted from the paycheck. On the contrary, a Roth IRA is set up between an employee and an investment firm. In this case, the employer of the employee is not involved. As opposed to 401(K), here, money used is after tax deductions.
The decision to choose 401(K) boils down to the question ‘when do you want to pay your taxes? Based on whether you will be in a higher tax bracket today as compared to when you will give you a hint about choosing this plan. If you think that the tax rate when you retire will be lower than the one in the present, then you should go for a 401(K) plan. In this way, you will not have to pay higher taxes today when you are in a higher tax bracket.
The name comes from where this plan has been defined, i.e. 401(K) section of IRS code. There are many schemes to choose from by the employee. But none of the gains from these schemes is taxed by the IRS. Taxation only occurs once the employee has reached the retirement age. As of 2019, the limit for annual 401(k) contributions for those under the age of 50 rises to $19,000 from $18,500, the 2018 limit. Those age 50 and older can contribute an additional $6,000 per year in catch-up contributions.
Benefits of 401(K):
- Your contributions might result in tax savings during each year of contribution.
- By using this plan, you actually can contribute a lot more each calendar year.
- You may get an employer match, i.e. contributing additional money to the employee’s account, which is usually a percentage of the employee’s contribution.
- The money that you contribute towards the 401(k) plan can be taken directly out of your paycheck.
Deviating from the traditional route, Roth IRA does not involve the employer in the picture. It is just about the individual or the employee and the investment firm. Moreover, the contributions made by the individual are after-tax deductions. Roth IRA is more flexible as compared to 401(k) for employees as they have more to choose from. This gives employees a greater degree of investment freedom. Since after-tax money is used to fund the Roth IRA scheme, hence no income tax is levied at the time of retirement when the money is withdrawn.
In 2019, the maximum annual contribution for those under the age of 50 was $6,000, up from $5,500 in 2018. Those age 50 and up can contribute an additional $1,000 for a total of $7,000/$6,500 per year. Individuals who earn more than $137,000 per year in 2019 ($135,000 for 2018) – or $203,000/$199,000 for those married filing jointly – are ineligible to contribute. Below those limits, there is a phase-out income group for whom partial contributions are possible. The range for 2019 is $122,000 to $137,000 ($120,000-$135,000 in 2018) for individuals and $193,000-$203,000 ($189,000-$199,000 in 2018) for those married filing jointly.
This scheme for the employers of the individuals makes sense if they feel that the income tax bracket that they will fall in at retirement will be higher than they are currently in. Usually, the Roth IRA contributions must be made in cash. But there are a variety of investment options within the Roth IRA that once the funds are contributed, including bonds, stocks, mutual funds, ETFs, etcetera.
Benefits of Roth IRA:
- Your withdrawals at the age of retirement will be tax-free since you had already made after-tax contributions.
- You can withdraw your money at any time without penalty (cannot withdraw before the age of 59 without incurring a penalty).
- This scheme gives you the freedom to choose the brokerage firm and also the investment options as opposed to 401(K).
Head to Head Comparison Between 401(K) vs Roth IRA (Infographics)
Below is the top 6 difference between 401(K) vs Roth IRA:
Key Differences Between 401(K) vs Roth IRA
Both 401(K) vs Roth IRA are popular choices in the market.
- Contributions by the employer: In 401(K), the employer might fund up to a certain percentage of your contribution. When an employer gives such an incentive (free money), it must be put to use. This is not the case with Roth IRA, in which after-tax deductions result in a pure contribution by an individual.
- Investment options: Although you get a benefit of a contribution by an employer in 401(K), this might not be sufficient as the investment options’ power vests with the employer. This narrows down your choices. On the other hand, in Roth IRA, the individual is free to choose from the investment firm and a plethora of investment options. The person can choose the investment manager.
- Tax: There is also a difference between 401(K) vs Roth IRA schemes when it comes to how the schemes are funded. In 401(K), the funds are contributed to the pre-tax income, while for Roth IRA, the funds are contributed to the after-tax income. It means that when you withdraw the money at the age of retirement, for 401(K), you need to pay taxes that were not paid earlier. But in Roth IRA, since taxes were already paid up hence no need to pay taxes at the time of withdrawal.
Head to Head Comparison Between 401(K) vs Roth IRA
Below is the 6 topmost comparison between 401(K) vs Roth IRA:
Basis of Comparison
|What is it?||Income plan for employees offered by employers to contribute an amount before tax deduction to save on higher tax post-retirement.||Income plan for individuals set up with an investment firm that seeks a certain amount after-tax deductions to save on higher tax later on post-retirement.|
|Before or after-tax deductions||Before||After|
|Control||With the employer.||With the employee.|
|Employer assistance (Free money)||Yes||No (the employer is not involved at all)|
|Freedom to choose management and investment firms?||No||Yes
Conclusion – 401(K) vs Roth IRA
So we had a look at two of the income plans that could potentially help an individual at the time of retirement based on the income tax brackets that they are currently in. We saw 401(K) vs Roth IRA. 401(K) should be your first choice if you think that the income tax rate when you retire will be higher as compared to today’s rate. Otherwise, Roth IRA is better in case you feel that the tax bracket under which you fall at retirement will be higher than the one in which you are today. So it depends on person to person.
This has been a guide to the top difference between 401(K) vs Roth IRA. Here we also discuss the 401(K) vs Roth IRA key differences with infographics and comparison table. You may also have a look at the following articles to learn more –