Roth IRA vs. Roth 401(k) – Which One is the Better Option for Retirement Savings Accounts?

By | February 21, 2020

One of the most important financial decisions before anyone is the choice of saving for retirement – the ability to make smart investment decisions that will go a long way in affecting our future. It is a decision that requires utmost care and consideration because the decision-maker bears the brunt if the outcome of the investment turns out less than favorable.

If you are already employed, it is very likely that you are signed up for at least one retirement savings plan. If you are not yet signed up for any, it would be a good time to start considering one. It is pertinent that you talk to your financial advisor at this juncture or seek the help of one if you don’t have any.

It is also important that you seek information about the available retirement savings accounts and which is the most appropriate for you considering your current financial situation. This article highlights 2 great retirement savings types and the advantages of both, while providing a rich source of information and education for you. Our focus in this article is on Roth IRA and Roth 401(k) and the benefits you stand to enjoy from these retirement savings accounts.

Areas to cover in this article:

  • Traditional vs Roth-Type Retirement Savings Accounts
  • Roth-Type Retirement Savings Accounts
  • Roth IRA and Roth 401(k) Similarities
  • Roth IRA and Roth 401(k) Differences
  • Pros and Cons of Roth-Type Retirement Savings Accounts
  • Which Option is Better?
  • Tips to Get You Ready for Retirement
  • Conclusion

Traditional vs Roth-Type Retirement Savings Accounts

When it comes to choosing a retirement savings account for your future, there are a number of available options out there. You need to educate yourself first on these available options to put you in the best position possible.

The traditional retirement savings accounts have been with us for quite a while, and depending on who you are or your employers, you would have signed up for one by now. The most common types of retirement savings accounts are IRA and 401(k) retirement savings accounts.

Traditional 401(k) is a financial retirement plan that is sponsored by your employer. There is no need for you to open or fund the accounts by yourself. Your contribution to the 401(k) account is done by designating a portion of your paycheck to go towards your plan. Funding of 41(k) is done with pre-tax income which means that you have to pay taxes on the money when you make withdrawals at retirement.

Employers may decide to match an employee’s 401(k) contributions to a certain percentage of their income. A typical example is an employer matching 50% of the employee’s contributions up to 6% of their salary though the exact matching terms is dependent on the employer.

Roth-Type Retirement Savings Accounts

Roth accounts have been steadily growing in popularity within the past few years, particularly because of the benefit of allowing your savings grow without tax deductions. There are 2 major types of Roth accounts namely Roth IRA and Roth 401(k).

A lot of questions have been asked about these 2 types of accounts. People want to know their similarities, their differences, which one is best for them, and if there is a possibility of participating in both at the same time. These and many more similar questions will be addressed in this section and subsequent ones.

A Roth IRA (Individual Retirement Account) is an individually-owned account that you set up with a financial institution (could be a bank or financial institution) which is funded from after-tax income. The implication is that you cannot deduct your contributions at tax time and when it gets to the time when you withdraw your savings during retirement the income isn’t taxable.

Roth IRA is the older of the 2 retirement savings account having been introduced to Americans in 1997 while the retirement savings vehicle named Roth 401(K) was introduced in the year 2006. Even though Roth IRA and Roth 401(k) share some similarities, their differences are much more than what they both have in common.

Roth IRA and Roth 401(k) Similarities

Both account types allow the investment from your savings to grow without any burden of taxation. This may result in a much bigger returns on investment when you are ready to start making withdrawals at retirement.

They also offer the benefits of withdrawing money from both retirement account types tax-free after you are 59 1/2 years old. You will enjoy more favorable tax treatment at retirement because there aren’t any taxes to be paid on distribution after the age of 59 1/2.

Roth IRA allows penalty-free withdrawal on contributions but imposes tax and penalties for any withdrawals made before 59 1/2 with a few exceptions. Withdrawals before 59 1/2 on Roth 401(k) are usually taxed and assessed a penalty.

Roth IRA and Roth 401(k) Differences

Both Roth-Types Retirement Savings accounts share a number of similarities with the most obvious been the tax treatment received when making withdrawals at retirement. They also have lots of differences which you should be familiar with in the case that you decide to opt for one of the options.

This section highlights the main differences between Roth IRA and Roth 401(k).

I. Contribution and Income Limits

Contributions and income limits are the most obvious difference between Roth IRA and Roth 401(k) with Roth 401(k) having a higher contribution limit of that allow employees to save up to $19,000 per year, and for employers over the age of 50 the limit is $25,000 per year. Contribution limits for Roth IRA are much smaller and for 2020 they are: $6,000 if you are under age 50 and $7,000 if you are age 50 and above.

Roth IRA contribution have limitations if a couple’s modified adjusted gross income in 2019 is $203,000 and above or $137,000 and above for singles then the account are off-limits.

II. Eligibility Criteria

The only required eligibility for a Roth 401(k) is that your employer offers this option to its employees. You will have to check if your current or proposed employer has a Roth 401(k) in place if you are interested in it.

For Roth IRA there is no employer restraint as it is a retirement savings account set up by you with a financial institution. You have lots of flexibility on how it should be run and a lot of control over your account.

III. Required Minimum Distributions (RMDs)

There is no need to take RMDs from Roth IRA but with Roth 401(k) you must start taking RMDs when you get to the age of 70 1/2 years old.

Another benefit with Roth IRA is that it isn’t required to start taking contributions while the account holder is alive and in the case of the account holder passing away, their spouse only would not be required to take contributions or to pay taxes.

Anyone else apart from the spouse who is listed as beneficiary is required to withdraw a minimum amount annually.

IV. Employers Match

The worker’s contribution is matched by employer which is a form of bonus or free money in Roth 401(k), even though the employer’s match is placed into a traditional 401(k).

In the case of workers who divide their contributions between the traditional 401(k) and Roth 401(k), they will have their company match applied to the traditional 401(k).

Investment options for Roth 401(k) are limited to the choices of your employer but this will be limited to just a few options. The Roth IRA gives you more control over your investments and the investment options are subject to what you decide.

V. Rules for Early Withdrawals

There are rules for early withdrawals of funds from Roth IRA and Roth 401(k) which are tax-free if they are able to meet the following criteria:

The said account must have been held for at least 5 years.

Pros and Cons of Roth-Type Retirement Savings Accounts

Roth 401(k) enjoys the advantage of employers matching your contributions to a certain percentage, a privilege that Roth IRA doesn’t share. Also note that the employer Roth 401(k) matching funds goes into a traditional 401(k).

Based on an employee’s investment appetite, it might pay more to maximize match from your employer while funneling extra retirement dollars into a Roth IRA.

Roth IRA has more investment options because you are at liberty to choose from a wide range of investment instruments like stocks and bonds, since you are the active manager of your Roth IRA funds. While investment options for Roth 401(k) is limited to your employer’s 401(k) plan.

Roth IRA offers savings benefits for low income earners because the Roth IRA is funded with after-tax income making withdrawals tax-free.

Which Option is Better?

When it comes to financial matters there is really no better options, rather what we have are options that best fit our financial goals and expectations. You should have a checklist that itemizes what you want your retirement savings account to achieve for you.

Here are some options to consider for both Roth-type retirement savings accounts:

Roth IRA is better option if:

  • You prefer the flexibility of choosing investment options from a wide range of available choices.
  • You want control over investment decisions that are made on your retirement savings
  • You would like to be able to make withdrawals of your contributions tax and penalty-free before you turn 59 1/2 years old without making plan loan
  • You do not want to be in a position to take RMDs at 70 1/2 years

Roth 401(k) is better option if:

  • You fall under high income earner who already has Roth IRA
  • You want to enjoy the benefit of an employer match
  • You want to be able to contribute as much money as possible
  • You would like to take advantage of the ease in signing up for a retirement savings account at the workplace and have your contributions automatically deducted from your paycheck

Both Roth-type are great retirement savings options for you, the important thing to consider is having one that suits your particular investment needs, or going for both if you have the financial capacity.

Tips to Get You Ready for Retirement

Here are a few tips to help you get started with retirement plans if you haven’t started one already:

  • Educate yourself about investments. Learn as much as possible to help you make informed financial decisions with respect to investing for the future.
  • Seek the guidance of a financial advisor before making any major investment decision
  • Start laying aside a portion of your monthly earnings as savings. These savings will be used for your investments.
  • Have a monthly financial budget and stick to it as much as possible
  • Plan your spending to avoid frivolous or impulsive spending
  • Find out the available investment vehicles that your employer has for its workers
  • If you are not happy with your current retirement savings plans, do something about it to make it right for you. Remember that you have to seek counsel from your financial advisor should you have to need to change your retirement plans.

Conclusion

When it comes to making plans for your retirement savings it is never too early to start no matter what age you are. You have to weigh the available options out there while considering your financial goals and your current financial situation. What works best for someone else may not be the most appropriate for you.

A good approach is to consider a plan that accommodates both Roth IRA and Roth 401k taking advantage of their strengths. Consider the contribution and income limits of both and plan accordingly in line with their requirements. If you have the money for both retirement savings accounts, have a mix of both.

For those who prefer to have more flexibility in their retirement savings account so they can have control while taking decision making responsibility on how funds are to be allocated, Roth IRA is a more preferable option for them. While Roth 401(k) gives the added benefit of employer matching your contributions to a certain percentage. You can opt for both or either depending on which benefit appeals to you.

It is worth mentioning that the content of this article is informational and that any financial decisions may have to be preceded by consultation with your financial advisor.

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