Retirement may seem like a long way away, but time moves quickly and it could be here before you know it. That’s why it’s important to establish a lucrative, reliable retirement savings and investment solution now. The most common types are Roth IRA and 401(k) accounts. They may seem similar, but they have a handful of differences that may make one option more suitable for you than the other.
How are a Roth IRA and 401(k) similar?
Fundamentally, a Roth IRA and a 401(k) have the same goal: to help you invest your retirement savings during your working career. The accounts will grow tax-free until you’re ready to end your normal employment arrangement and start enjoying your golden years. Both accounts allow your savings to grow tax-free but — as Jean Folger of Investopedia outlines — they differ in tax treatment, investment options, and employer contributions.
What is a 401(k)?
Kristie McCauley of The Simple Dollar offers this definition of what a 401(k) is. “A 401(k) is an employer-sponsored plan that is often included in the benefits package of a full-time job. If you elect to use a 401(k), you can sign up through your employer,” though she points out that your account will likely be managed by an investment firm. When you set up a 401(k) account through your employer, you allocate a portion of your paycheck to go directly into your 401(k) account instead of routing to your checking account.
What is a Roth IRA?
Rather than going through your employer to establish your retirement savings account, you could work directly with an investment firm. This allows you to establish a Roth IRA account, which McCauley says may give you greater freedom in your investment strategies. You contribute money from your savings account to this investment account every year. A Roth IRA — which stands for “individual retirement account” — is often taken by those who are self-employed or whose employer doesn’t offer a 401(k) plan.
Key differences
According to Ramsey Solutions, a primary difference between a 401(k) and a Roth IRA is how they’re taxed. Because the former is deducted from your paycheck before income taxes are calculated, which reduces your taxable income, you’ll have to pay taxes when you start withdrawing from your 401(k) upon retirement. On the other hand, the money you contribute to a Roth IRA has already been taxed by the IRS as part of your income. So, when you begin receiving disbursements from your Roth IRA, the money will be tax-free.
A benefit that a 401(k) offers which a Roth IRA does not is that oftentimes employers offer to “match” the amount of money you contribute to your 401(k) account up to a certain amount. For example, an employer may match 50 percent of your contributions up to 6 percent of your salary or 100 percent of your contributions up to 3 percent of your salary. After a vesting period, those employer-contributed funds in your account belong to you.
You can also contribute more money annually to a 401(k) than you can an IRA. While the IRS can change the cap on your annual contributions to these accounts as tax laws change, you can typically contribute over three times as much to a 401(k) in a given year than you could to a Roth IRA.
The good news is that you can contribute to both types of accounts at the same time and adjust your contributions as your employment situation changes over the course of your career. Talk with an investment adviser to determine what the best solution is for your financial situation.