401(k)s and Roth IRAs: Here’s the difference
No matter how young or old you are, saving for retirement is important. To help you be as secure as possible, diverting a portion of your paycheck into a tax-advantaged retirement savings plan, for example, your wealth can grow exponentially to help you get set for retirement.
Even though many are thinking about or saving money in different places, just two-thirds of current employees find it easy to understand the retirement benefits offered to them, according to a 2020 survey from the Employee Benefit Research Institute.
The Sum breaks down 401(k)s and Roth IRAs, including the pros and cons of each.
Did you know there are two basic types of 401(k)s?
The traditional 401(k) reduces your taxable income, but you’ll pay taxes when you take money out for retirement.
Contributions you make to a Roth 401(k) are taxed before, so you can withdraw tax-free.
Once you have your contributions set up, you need to invest that money. Two options are mutual funds or exchange-trade funds.
This year, your individual contribution limit is $20,500 (or $27,000 if you’re 50 or older). But the limits increase next year: $22,500 for individuals, or $30,000 if you’re 50 or older. Employer contributions don’t count toward these limits, but are capped by the total contribution limit.
Matching employer contributions means your employer duplicates a percentage of your contributions. Non-matching contributions mean your work shares a percentage of profits.
If your work doesn’t offer a 401(k), you can still sign up for an individual retirement account.
What is a Roth IRA?
A Roth IRA (individual retirement arrangement) is a type of retirement account where your money grows tax-free. You’ll pay taxes on the money before making contributions, but you can withdraw tax-free.
If you think your taxes will be higher when you retire than they are now, this could be a good option for you. With a traditional IRA, you pay taxes when you start withdrawals but take a tax break when contributing.
In 2023, if you make less than $138,000 you can contribute up to the limit. If you’re married and filing taxes together, you must make less than $218,000. You can put up to $6,000 in your account this year. In 2023, that limit goes up to $6,500. Also, you can only contribute income that you earned.
The account must be open for at least five years before you can start withdrawing at 59 1/2.
What are the pros and cons of Roth IRAs?
Roth IRAs tend to be attractive to people because you can invest after-tax dollars, meaning money you’ve already paid taxes on, and enjoy tax-free growth and withdrawals. Some people love not having to worry about taxes when they withdraw their savings when they’re ready for retirement. But there are also cons, like there is no upfront tax deduction, to consider.
What are the pros and cons of 401(k)s?
In the U.S. retirement market, 401(k)s represent almost one-fifth of the total, according to the Investment Company Institute (ICI). But to really understand, you need to know the ins and outs.
With one of these, employees can defer some of their salary (often with a match from their company). Instead of receiving that amount in their paycheck, the employee can invest that money in their 401(k) in bonds, mutual funds and other assets.
The capital gains earned from these assets grow tax-deferred—meaning the account holder won’t pay taxes on that money until they withdraw it (usually in retirement).
In addition to the pros and cons of this plan, you should know the following:
- You can have other retirement plans.
- You can be a business of any size.
- You may have to file a Form 5500 annually.
Sources
- Investopedia: What is a 401(k) and how does it work?
- Forbes: 401(k) Contribution Limits For 2022 And 2023
- Nerdwallet: What Is a Roth IRA Account?
- Investopedia: What Is a Roth IRA?
- The Smart Investor: Understand The Pros And Cons Of 401k Retirement Plan
- Yahoo Finance: Pros & Cons of a 401(k)
- IRS: Choosing a Retirement Plan: 401(k) Plan
- Investopedia: Disadvantages of Roth IRAs Every Investor Should Know
- Bankrate: Roth IRA vs. traditional IRA: Which is better for you?
- Nerdwallet: The Pros and Cons of a Roth IRA
- Bankrate: 9 best retirement plans in November 2022
This story was originally published November 14, 2022 at 2:03 PM with the headline "401(k)s and Roth IRAs: Here’s the difference."
