401 k vs Roth IRA

Roth IRA

In this post, I am going to compare a Roth IRA versus a 401k plan and recommend which one is better for you in your situation.

What is a Roth IRA and 401k?

Roth IRA (Individual Retirement Account) is essentially a self-directed retirement account.

A 401k, on the other hand, is an employee-sponsored retirement account.

These are two main ways that you can invest and save for your retirement.

Roth IRA

The first nuance of the Roth IRA is that you’re investing using after-tax dollars.

In other words, you’re funding your Roth IRA with your take-home pay.

Keep in mind that a Roth IRA is just a vehicle to help your money grow tax-free.

You will have access to this money during retirement.

Inside your Roth IRA, you can choose to invest in a variety of different investment options. They range from stocks, bonds, mutual funds, index funds, real estate funds (REIT), cryptocurrency, and commodities among others.

If you opened a self-directed Roth IRA, you can invest in real estate companies, LLCs, just to name a few alternative investments you can use with a Roth IRA account.

Let’s just keep this simple, and we are planning on using our Roth IRA to invest in index funds.

Advantages of a Roth IRA

One of the best advantages of a Roth IRA is that your money will grow tax-free.

On a similar note, tax rates can change. You’re hedging against future tax rate hikes since you’ve already paid your taxes now.

An additional perk to the Roth IRA is that you have access to your contributions at any time without penalty.

What this means is that you can withdraw your original Roth IRA contributions tax-free, penalty-free and worry-free since this is your after-tax money.

So in summary, you can take out your contributions but you cannot take out your gains or profits.

Roth IRA example

For example, let’s just say I invested the maximum 2019 Roth IRA of $6,000. I can withdraw this amount at any time without any penalties.

One caveat to remember is that once you withdraw money, you cannot change your mind and reinvest that money. You are limited to the yearly contribution maximum.

Remember we are just talking about your original contributions. If that $6,000 has grown to $7,000 then you cannot withdraw that $1,000 in profit.

You can withdraw that profit when you’re 59.5 years old.

The third most important factor in a Roth IRA is that you don’t have to worry about required minimum distributions (RMD).

If you have a traditional IRA account, you have to take out minimum distributions when you reached 70 and 1/2 years old similar to the traditional 401k.

Let’s just say you have been doing awesome with your Roth IRA investment and you reached $1 million. Without the RMD, you can just leave that money in the account indefinitely.

This comes in handy when you’re performing estate planning and/or wanting to leave that money to your heirs.

The neat thing about passing the money onto your heirs through a Roth IRA is that there’s no inheritance tax.

If you’re into giving and charity, you can choose to designate your money to your favorite charity or philanthropy group.

Pros of Roth IRA

  • All profit is tax-free after age 59.5
  • You can withdraw contributions tax-free (not profits or gains though)

Cons of Roth IRA

  • Post-tax money means no tax write-off versus 401k or traditional IRA
  • If you withdraw profit before the age of 59.5 you have to pay 10% penalty plus ordinary taxes
  • Limited to $6,000 per year vs $19,000 for 2019 or $19,500 for 2020

Contribution and withdrawal limits

The maximum contribution to a Roth IRA for 2019 is $6,000. If you’re over 50 years old you can contribute up to $7,000 in what is known as a catch-up contribution.

You can freely withdraw both your gains and contributions starting at the age of 59 1/2 tax-free and penalty-free.

If you decided to take out both the original contribution and including gains before age 59 1/2 then you’d have to a 10% penalty on your gains plus ordinary taxes.

For example, if you contributed $500,000 and gained another $500,000, you’d have to pay 10% on the $500,000 gained and also pay ordinary income tax.

Income limit

Unfortunately, there are income limits to a Roth IRA contribution.

If you’re filing as a single income earner or the head of the household and earned more than $124,000 per year then you can’t contribute to a Roth IRA.

On the other hand, if you’re filing jointly or married, the maximum contribution limit is no more than $196,000 per year.

Roth IRA income and contribution limits for 2020

Filing status2020 modified AGIMaximum contribution
Married filing jointly or qualifying widow(er)Less than $196,000$6,000 ($7,000 if 50 or older)
$196,000 to $205,999Contribution is reduced
$206,000 or moreNot eligible
Single, head of household or married filing separately (if you did not live with a spouse during the year)Less than $124,000$6,000 ($7,000 if 50 or older)
$124,000 to $138,999Contribution is reduced
$139,000 or moreNot eligible
Married filing separately (if you lived with spouse at any time during the year)Less than $10,000Contribution is reduced
$10,000 or moreNot eligible

Lastly, when it comes to a Roth IRA, you can only contribute what you earn in a given year.

Let’s say you work at Starbucks part-time and only earned $3,000 for 2019. You’re only allowed to contribute $3,000 for 2019 unfortunately.

Traditional 401k

In contrast to the Roth IRA where your contribution is after tax. The traditional 401k contribution is using before tax or pre-tax dollars.

The benefit of using pre-tax money is that it is tax-deductible.

Let’s say pharmacist Andrew earn $100,000 per year and contributed $6,000 toward his 401k.

Andrew’s gross income is only $96,000 due to the $6,000 deductible. So Andrew now pay less taxes for the year because he made contributions to his 401k plan.

The other very important benefit for a 401k plan is the employer match. This is essentially free money given to you as a benefit of working for your employer.

The match is where your employer allows you to contribute and they will match your contributions.

Typical match ranges from zero to 6 percent of your salary and from zero to 100 percent of an employee’s contribution.

Let’s go back to the example of Andrew, he contributed $6,000 to his 401k plan. His company will also contribute a matching contribution. For simplicity, let’s say his company contribute will contribute up to 6% of his salary and will match 100% of his contribution.

If Andrew contributed $6,000 and gets a $6,000 match then he’s got $12,000 invested in the 401k account for that year.

The 401k contribution will grow tax-deferred but it’s also a double-edged sword. It’s because contribution is tax-deferred, not tax-free. You will have to pay ordinary income taxes later when you withdraw the money.

So let’s say Andrew managed to save $1 million dollars and is ready to retire. Whatever tax bracket that he’s in at the time of his withdrawal will be his tax rate.

If you’re in a higher tax bracket at the time of your retirement then you have to pay higher taxes.

Pros of traditional 401k

  • Tax write off (pre-tax money)
  • You can contribute $19,000 per year in 2019 and $19,500 in 2020
  • Employer match (free money)

Cons of traditional 401K

  • You pay taxes later after the age of 59.5
  • If you withdraw money early with a few exceptions (financial burden), you’ll have to pay a 10% penalty and ordinary income taxes
  • Forced to withdraw some money at the age of 70.5 (required minimum distribution aka RMD)

401k Eligibility

The maximum contribution of the 401k program is higher than the Roth IRA. For 2019 the maximum contribution is $19,000.

There’s also a catch-up contribution of $6,000 on top of the $19,000 if you’re older than 50.

In 2020 the IRS increased the limit from $19,000 to $19,500 while the Roth IRA limits remained the same.

The catch-up contribution for the 401k plan will increase by $500 to $6,500 in 2o2o as well.

The other benefit of the employer match is that it does not count toward your own maximum contribution.

Similar to the Roth IRA, the withdrawal age for the 401k plan is 59 1/2.

You can take out loans from your 401k prior to age 59.5. However, it’s generally not recommended since you have to pay interest and penalty when you do so.

Roth IRA vs 401k Summary

When to go for Roth IRA:

  • Best if you’re in a lower tax bracket and expect to be in a higher tax bracket during retirement
  • Worse if you’re currently in a high tax bracket now but will be in a lower bracket when you’re retired

When to go for traditional 401k

  • Best when you’re making a lot of money right now (tax-deductible)
  • If you expect to retire in a lower tax bracket
  • Uncertainty of future tax rates

For the last bullet point, for example, tax deferral will be counterproductive if future tax rates will be much higher. When you’re ready to withdraw the money then, you’d have to pay much higher taxes.

If you’re young and in a lower tax bracket, you should prioritize the Roth IRA. Your tax-free money has all that time to grow and compound. You will not regret it later in life when you’re older.

However, on the other hand, if you’re making a lot of money right now and in a really high tax bracket and you don’t expect this income level to last. And if you’re expecting to retire in a lower tax bracket then you should prioritize traditional 401k.

But why limit yourself? You can find a balance and contribute to both accounts for the simple reason of not knowing about future tax rates.

There’s also the Roth 401k option to entertain. Just like Roth IRA, Roth 401k is funded using after-tax money.

Still unsure which option is better? There’s always a calculator for that.

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