Roth vs 401k – Which is Right for You?

Planning and investing for retirement can seem challenging and even frustrating at times. Many people are concerned about not having enough money in retirement or about their nest egg losing value as they approach retirement age if the market takes a sudden and expected turn. While it is impossible to accurately predict and thoughtfully prepare for all scenarios, there may be steps that you can take to position yourself for an increased likelihood of achieving financial success. Choosing the right type of retirement account for your plans is an important first step to take. With a closer look at a Roth vs 401k plan, you may be able to more strategically set up your portfolio.

What Is Roth?

When looking at a Roth retirement account, it is important to note that there are both Roth IRA and Roth 401k accounts, and both of these differ from a traditional 401k account in important ways. Both of these Roth accounts use after-tax income as contributions, and the withdrawals later in your retired years are tax-free.

There are also differences in the contribution limits between a Roth IRA and a Roth 401k. With a Roth IRA, you can contribute up to $5,500 per year into this retirement account if you are under the age of 50. If you are over the age of 50, you can contribute up to $6,500 per year.

On the other hand, with a Roth 401k, the total combined contributions from the employer and employee cannot be more than $53,000 if the employee is less than age 50. Additionally, it cannot be more than $59,000 per year if the employee is older than 50 years old. When comparing a Roth vs 401k retirement plan, the contribution limits can play a major role in determining which account fits your needs best.

What Is 401k?

When you want to learn more about a Roth vs 401k plan, a closer look at a traditional 401k plan is in order. The traditional 401k contribution limits are the same at the limits for a Roth 401k described previously. Therefore, they are considerably higher than the Roth IRA contribution limits. However, unlike with both types of Roth accounts, the traditional 401k uses pre-tax income as contributions. The employer may also contribute funds to this account that can grow on a tax-deferred basis over the years.

The funds will grow based on the type of investments that you select, and the employee typically has full control over how the funds are invested and diversified. However, the brokerage firm’s investment options may be a limiting factor in this area, and this is because some brokerage firms only offer a handful of investment options.

Because this type of retirement account uses pre-tax dollars as contributions, the contributions and growth are taxed later in retirement when you begin taking withdrawals. The earliest date that you can begin taking distributions from the Roth account is at age 59 and a half. This also applies to the distributions you will take from the traditional 401k account. If you plan to retire earlier, you may need additional sources of income to rely on before the age of 59 and a half, such as rental income from real estate investments.

Bonus read – How does 401k work?

What Is the Difference Between Roth and 401k?

Now that you know more about a Roth vs 401k retirement account, you may be wondering what the specific differences between these options are. A closer look may help you to determine which option is most well-suited for your unique requirement plans.

1. Contribution Limits

While the contribution limits for a Roth 401k and a Roth IRA are the same, the limit for a Roth IRA is substantially lower. Some people may not plan to invest this much money into their requirement account each year, however. Therefore, a contribution limit difference may or may not be a critical factor for you to consider when deciding which type of retirement account you should use.

2. The Impact on Your Current Tax Bill

One of the key benefits associated with using retirement accounts versus simply investing your funds in a non-retirement investment account is related to tax benefits. However, the impact on your tax liability between a Roth vs 401k account is substantially different. A Roth account uses the pre-tax money, and this means that it has no impact on your current tax liability. While a traditional 401k account can channel a substantial amount of your gross income to prepare for retirement. As a result, this can directly reduce your tax liability now in your working years.

3. The Impact on Your Post-Retirement Tax Bill

These different retirement accounts also vary substantially with regards to your potential tax liability in the future. With a traditional 401k account, you are able to take out distributions without affecting your future tax liability. With a Roth account, on the other hand, the contributions and growth will be taxed. However, your tax rate may be lower in your retirement years than it currently is. This means that your overall taxes paid on these funds could potentially be lower.

So, Which One Is Best for You?

If you are trying to decide between a Roth vs 401k account, there are two points to consider.

1. The Amount You Want to Invest

The first point is to determine how much money you want to contribute annually to your retirement account. If you plan to contribute less than $5,500, all of the retirement account options discussed may work well for you. However, you may plan on contributing more than this amount each year. In this case, using a Roth 401k or a traditional 401k is more advantageous for your plans.

2. Take into Account Taxes

The second point to consider relates to your taxes. You must first review your previous tax return to determine what your current tax rate is. Then, you must analyze your projected finances in retirement to estimate your tax rate at that time. This can be challenging to do because a large portion of this estimate is speculative. After all, you may not know exactly what your income level will be in retirement. Furthermore, you may not know how large your distributions from the retirement account may be.

There is also a possibility that the tax rates themselves can change between now and then. Tax tables adjust periodically because of changes to tax code and law. Nonetheless, if you want a significantly lower tax rate later, a Roth IRA or Roth 401k is a smart idea. However, if you plan to receive taxable income from other sources in retirement, such as from dividends or rental properties, the benefit of tax-free distributions from a traditional 401k may work in your favor.

There is no catch-all answer regarding which retirement account is best. As you can see, factors related to the amount you want to contribute as well as your present and future tax status must be carefully analyzed before you can decide between a Roth vs 401k. Because of the differences between these accounts, you can easily make an informed decision. This decision sets you on a path for success when you understand how these differences can work in your favor.

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