One person will invest with high fees, low contribution limits, and a big tax bill.
While the other person’s investment will grow exponentially with low fees and less taxes.
What are you going to do about your low performing retirement strategy?
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If you read this blog until the end, you’ll know the differences between IRAs and 401ks so that you can retire with substantially more money.
So, let’s get into it.
The Difference Between Roth IRA and 401k Plan
So, both 401ks and Roth IRAs are popular retirement savings accounts that give investors tax advantages.
Their key differences are how they treat taxes, their investment options, and employer contributions.
We’re covering what is a 401k, what is an IRA, and how to invest depending on what your employment scenario looks like.
In a perfect scenario, you would be investing in a 401k AND the Roth IRA.
However, if you have to decide between the two, let’s start off by talking about what is a 401k?
What is a 401k?
401k Contribution Limits
Notably, 401ks contribution limits are much higher than Roth IRAs.
Meaning, you can invest much more money into your 401k than you can invest into a Roth IRA.
For 2020, the 401k contribution limit is:
- $19,500 if you’re under age 50
- $26,000 if you’re age 50 or older
This is quite a bit of money.
Since the average salary in America is $48,672, $19,500 would be 40% of the average American’s gross salary.
Now, I’m going to break down some math in this blog.
So, since the average employer match is 4.3%, let’s assume that you’re saving 4.3% of your income 401k investments.
4.3% of $48,672 is $2,092 a year, or $40 per week.
According to Nerdwallet’s calculator, if you start at 30 years old and save $40 per week into your 401k, you’ll have $403,000 at retirement.
401k Employer Match
But, let’s be real. We’re all trying to get that free money from our employers.
We’re trying to squeeze them.
The real reason we want to invest in 401k plans is to get an employer match.
This is literally the easiest way to double your money instantly.
And they usually match a certain amount of what you put into your 401k plan each week.
Meaning, if you put in a dollar, they put in a dollar, but only up to a certain dollar amount.
Remember that the average 401k employer match is 4.3% of your salary.
And remember that 4.3% of $48,672 is $40 per week?
So, this means that your employer would ONLY give you a maximum of $40 per week.
Now, this was just an example using the average American income.
Your income is most likely different so the contributions that you and your employer make will be different.
So, there are 401k contribution limits.
Meaning, you can only invest so much into your 401k each year.
For 2020, the TOTAL amount that you and your employer can invest in your account is as follows:
- $57,000 if you’re under age 50
- $63,500 if you’re age 50 or older
- 100% of your salary (if it’s less than the dollar limits)
Maybe you’re working a 2nd job part-time and you’re putting 100% of that money into your 401k investments?
401(k) and Taxes
The government generously gives you a tax break when you invest into your 401k.
You can deduct your contributions when you file your income tax return.
This reduces your taxable income, which saves you money.
But you’re not off the hook for taxes.
You’re going to pay taxes when you start pulling your money out of your 401k during retirement.
These distributions are subject to income taxes at the income level you’re at during retirement.
According to the Bureau of Labor Statistics, the average household income during retirement is $48,000.
If you think your income will be higher when you retire, you may want to plan ahead, as all income from your distributions will be taxed.
Assuming you’re married during retirement and that income tax brackets never change, you’d be at a 12% income tax during retirement.
Meaning, you’d lose 12% of the money that you’re pulling out of your 401k.
401k Plan Investing
If you’re comparing 401k plan investing to Roth IRA investing, the major appeal to just investing in a 401k is the employer match.
If you get 401k employer matching, that’s equivalent to a 100% return on investment.
It would take years in an IRA to achieve that same 100% return.
I’m not digging into the Rule of 72 here, but the Rule of 72 tells us that if we earn 6% in a Roth IRA, then it would take 11.9 years to get that same ROI that our 100% employer match gives us.
So, as you can see, that’s a pretty valuable aspect of 401k investing.
Because, over time, those contributions compound, leading to far more growth over the long term.
There are two other pieces of information to consider when comparing an IRA and a 401k and that’s cost and flexibility.
When you leave your job, you are no longer allowed to contribute to that employer’s 401k.
You then have to make a choice between keeping your 401k with your company or rolling it over to an IRA.
Sometimes you can even have the 401k from your previous employer rolled into the 401k in your new company.
As there are no more matching contributions, cost and flexibility should have greater importance for you.
So, now that we know a little more about the 401k, let’s talk about what is a Roth IRA?
What Is a Roth IRA?
Roth IRAs are individual retirement accounts that are set up between you and an investment firm.
With a Roth IRA, you get to cut out your employer as a middle man.
This means that how you manage your Roth IRA is not limited to what the employer’s plan offers you.
But with greater freedom comes greater fees.
Roth IRA fees are higher when compared to 401k fees.
Unlike the 401k, after-tax money is used to fund a Roth IRA.
Which means that you do NOT pay taxes when you pull this money out during retirement.
Roth IRA Contribution Limits
The Roth IRA contribution limits for 2020 are much lower than the contribution limits for the 401k.
For 2020, the maximum roth ira contribution is:
- $6,000 if you’re under age 50
- $7,000 if you’re age 50 or older6
Roth IRA Income Limits
However, keep in mind that your eligibility to contribute to a Roth IRA is based on your income level.
If you file taxes as a single person, your Gross Income must be under $139,000 for 2020 to contribute to a Roth IRA
And if you’re married and file jointly, your Gross income must be under $206,000 for the tax year 2020.
Now, with Roth IRAs, the more you earn, the less that you can invest.
If you’re under 50 years old, a full contribution is $6,000.
If you’re over 50 years old, a full contribution is $7,000.
For Roth IRAs in 2020, you can make a full contribution if your income is less than $124,000 for individuals and $196,000 if you’re married filing jointly.
If your income is above $124,000 for individuals and $196,000 for those married filing jointly, you can make a reduced contribution.
All of this means that if you earn more, you are NOT allowed to contribute as much.
Roth IRA Withdrawals
You can withdraw your Roth IRA contributions at any time or any age with no tax or penalty.
But Roth IRA withdrawals on earnings, could be subject to income taxes and a 10% penalty.
In general, you can avoid taxes and the penalty if your account is at least five years old and the withdrawal is:
- Made after you turn age 59½
- Taken due to a permanent disability
- Made by your beneficiary or estate after your death
- Used to buy, build, or rebuild your first home
Unlike 401ks, Roth IRAs have no Required Minimum Distributions during your lifetime.
If you don’t need the money in retirement, you can leave it in the account, where it can continue to grow tax-free for your beneficiaries.
So, now that we know what the difference between IRAs and 401ks is, let’s talk about which one is best for you.
The first scenario we will cover is if your employer offers a 401k match.
If your employer offers a 401k match
Let’s talk about the steps you should be taking if your employer offers a 401k match.
Contribute enough to get the full match.
The first one is to contribute enough to earn the full match.
If your employer matches any portion of the money you contribute to the company 401k plan, do not bypass this opportunity to collect your free money.
A company matching program is one of the biggest benefits of a 401k.
This 401k employer match is effectively a guaranteed 100% return on that money.
Also note that employer contributions don’t count toward the 401k annual contribution limit.
Contribute as much as you’re allowed into an IRA.
Next, contribute as much as you’re allowed to an IRA.
Depending on Roth IRA or traditional IRA you can get your tax break now OR down the road when you start withdrawing funds for retirement.
A traditional IRA is ideal for those who favor an immediate tax break.
Your IRA contributions may be tax deductible, which means your taxable income for the year will be reduced by the amount of your contribution.
This means that if you earn $56,000 per year and invest $6,000 into your traditional IRA, your taxable income will be $50,000 for the year.
A Roth IRA is a good choice if you want tax-free growth on your investments and tax-free withdrawals in retirement.
Roth IRA eligibility is not affected by you already having a 401k, but there are income limits like we mentioned before.
Revisit your 401k
So now that you have your 401k’s employer match and you have maxed out your IRA contributions, let’s assume that you want to invest MORE money into your retirement account.
What’s a girl to do?
After you do these two things and you have more money to invest, work on putting more money into your 401k.
Remember, we only invested enough into our 401k to get our employer’s match, but we never hit our limit on how much we can invest into our 401k.
So, now is the time to start working towards that 401k limit.
The money you contribute to a 401(k) will lower your taxable income for the year.
But what if your employer doesn’t offer a 401k match?
If your employer doesn’t offer a 401k match
Let’s talk about the steps you should be taking if your employer does NOT offer a 401k match.
1. Contribute to a traditional or Roth IRA first.
Make contributions to a traditional IRA or Roth IRA first.
Not all companies match their employees’ retirement account contributions.
When that’s the case, choosing an IRA and contributing up to the max is generally a better first option.
But why start with an IRA?
One of the biggest benefits of an IRA is that you can invest in any type of investments.
This gives you much more control over your investment options.
You can bargain-shop for low-cost mutual funds and ETFs instead of being restricted to only what your company offers.
And you can avoid paying the administrative fees that many 401k plans charge.
2. After maxing out IRA benefits, contribute to your 401k.
AFTER maxing out IRA benefits, contribute to your 401k.
Again, the 401k tax benefits is a good reason to direct dollars into a 401k after you’ve funded a traditional IRA or Roth IRA.
Unless you just have a really crappy 401k provider, then it may not even be worth it.
Crappy 401ks will charge you super high administrative fees and place your money into 401k investments with high fees.
Remember that if your income passes certain thresholds, your ability to deduct traditional IRA contributions may be reduced or eliminated.
But, if you aren’t eligible for a traditional IRA deduction, you may still be eligible for a Roth IRA deduction.
So, which is better – 401k or Roth IRA?
Hopefully this video answered the question of the main IRA and 401k differences.
In many cases, a Roth IRA can be a better choice than a 401k retirement plan
Because it offers a flexible investment vehicle with greater tax benefits.
Especially if you think you’ll be in a higher tax bracket later on.
However, if your income is too high to contribute to a Roth IRA and your employer offers a match, a 401k is hard to beat.
If you can manage it, a good strategy is to have both a 401k and a Roth IRA.
Invest in your 401k up to the matching limit, then fund a Roth up to the contribution limit.
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