Roth IRAs and 401ks are both popular ways of saving for retirement, but which option is right for you? To answer that question, you need to understand the difference between the two, and how they relate to your own situation. It is possible that a solid retirement strategy might include both a Roth IRA and a 401k.
What Is a 401K?
A 401k is a type of employer-sponsored retirement plan. If you have access to a 401k at work, then it's an easy way to start saving for retirement. Some companies match part of the contributions you put in your 401k.
If your employer offers contribution matching, then you should probably use a 401k to save for retirement, as it’s an effective way to receive what is essentially free money. However it should be noted that there is a limit on the amount of money you can contribute to a 401k account each year. In 2015, the limit is $18,000, with an extra $6,000 catch-up allowance for savers over 50.
You will not pay tax now on the money you defer into a 401k, but you will be taxed on the money when you withdraw it as retirement income. With a 401k or a traditional IRA, you will also be required to start withdrawing money after age 70-1/2, so it can be taxed as income.
What Is a Roth IRA?
An IRA, or individual retirement account, is a plan that anyone with earned income can use to save for retirement. Traditional IRAs work like 401ks in that you are not taxed now on income you defer into the account, but are when you withdraw it. Roth IRAs offer the opposite tax benefit: you put after-tax money in, but as long as the Roth has been established for five years, you don't have to pay income tax on money taken out after age 59-1/2. Importantly, you also are not required to take money out of a Roth IRA once you pass age 70-1/2 if you do not need the income.
The amount of new money you can contribute to an IRA or a Roth IRA in any one year is limited. The limit in 2015 is $5,500 for people under 50 and $6,500 for those over 50. In the past, to qualify for a Roth IRA, you had to have income below a certain limit. However, laws have loosened this so that even if your income is above the limit, you can convert IRA monies to a Roth IRA. You can also convert money that has already built up in an IRA or prior employer’s 401k to a Roth IRA. When you do, the converted money will be taxable income, but once in a Roth it is free to grow without being taxed again.
If you are currently in a tax bracket that is equal to or below what you expect your tax bracket in retirement to be, starting a Roth can be a great idea. You will have time on your side for the money to grow and create an asset that will be free of income tax when you use it during retirement. Conversely, if you are currently in a high income tax bracket and expect to be in a significantly lower one when you are drawing out money, then the Roth is less attractive. For people who are closer to retirement, figuring out the interaction of tax rates, social security, and IRA/401k/Roth income is an important consideration when mapping out your best retirement income strategy.
Should I Use a 401k or a Roth IRA to Save for Retirement?
If your employer offers contribution matching in a 401k, then this is likely your first option to use for retirement savings. However, you may choose to also open a Roth or traditional IRA to create a varied retirement portfolio. Opening an IRA is easy and you can do it on your own or with the help of an adviser, without going through your employer. It could also give you access to a greater range of investing opportunities, such as stocks, bonds, mutual funds and exchange traded funds.
Often, the best approach is to put money into an employer-matched 401k, and if you can save more money for your future, use a Roth or traditional IRA to top off your retirement savings.
If you need help mapping out your retirement strategy, contact a financial planner to discuss your personal retirement plan and find the right solution for you.