Reaching a point in your life when you no longer need to work is a dream come true for most people. Unfortunately, we all have bills to pay. That’s why saving for retirement is so important. You can do that on your own with a Roth IRA or contribute to an employer-sponsored 401(k) plan. You can even do both if you like. Read on to learn more.
What is a Roth IRA?
A Roth IRA is an individual retirement account that anyone can open. Contributions to a Roth IRA are made with after-tax dollars, meaning that you’ll be putting funds into it after you’ve already paid income tax on that money. Your distributions will then be tax-free when you’re in retirement, as long as you start taking them after you’re 59 ½ years old.
Independent contractors and self-employed individuals will often set up a Roth IRA to have at least some retirement savings, but the IRS does not restrict you from opening one if you already have a 401(k) or pension fund somewhere else. The maximum annual contribution limit for a Roth IRA is $6,500 per year, $7,500 if you are over 50 years old.
What is a 401(k) plan?
A 401(k) plan is an employer-sponsored retirement plan grown with tax-deferred contributions from the employee. Those contributions are deducted from your paycheck before taxes are taken out, so your taxable income for this year will decrease. That could also put you in a lower tax bracket, meaning you’ll pay a smaller percentage of your paycheck in income tax.
The IRS allows individuals to contribute up to $22,500 per year to a 401(k) plan, with an increase to $30,000 per year for individuals over 50 years old. On top of that, employers can match some or all ofyour contributions. Matching contributions don’t count towards your maximum contribution limit, but you will need to pay taxes on them when you take distributions.
Differences between Roth IRAs and 401(k)s
The primary difference between a Roth IRA and a 401(k) is the tax classification for contributions and distributions. With a Roth IRA, contributions are made after taxes, and distributions are tax-free. With a 401(k), contributions are tax-deferred, so you need to pay income taxes on them when they are distributed in retirement.
Another difference is the annual contribution limits. The IRS allows you to contribute $22,500 per year to your 401(k) plan ($30,000 if you’re over 50), but the annual contribution limit for a Roth IRA is only $6,500 ($7,500 if you’re over 50). The good news is you don’t need to choose between the two. The IRS allows you to have both.
The Bottom Line
It’s important to understand the differences between Roth IRAs and 401(k)s when saving for retirement. Tax-deferred contributions to your 401(k) can lower your tax liability for this year. Contributions to a Roth IRA can give you tax-free income in retirement. Contributing the maximum to both could give you compounded returns of $29,000 to $37,500 per year.
Sources:
https://www.investopedia.com/terms/1/401kplan.asp
https://www.investopedia.com/terms/r/rothira.asp
https://www.investopedia.com/ask/answers/12/401k.asp