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In today’s post, I will discuss the difference between the Roth IRA and a traditional 401(k)/457 retirement plan. Each investment vehicle serves a different purpose and one may suit you better than the other.
Pulling Out Your Money
Each investment vehicle is geared for retirement and you can not draw from them without a penalty until you reach the age of 59 1/2 – with the exception of the 457 plans. You can draw from a 457 plan upon separation from employment without penalty.
You can draw from your other retirement accounts (Roth, 401k) early if you are willing to take a 10% early withdrawal IRS penalty, but I would NEVER recommend giving the government an extra 10%. With that being said, convince yourself that drawing from your Roth or 401k before 59 1/2 is not an option and you will be OK.
Let’s break down the accounts to find out which one is best suited for you.
How Do You Fund The Accounts?
The 401(k) & 457
With the 401(k)/457 option, you are able to deposit money into this account, pretax. What are the benefits of this? With the pre-tax option, you are able to invest more money without feeling as large of a hit in your take-home pay. The funds are taken from your income checks before the government gets to touch/tax your income.
The Roth IRA
With the Roth IRA, your money is invested after tax so you will feel a bigger hit in your take-home pay. You are responsible for funding the Roth out of your after-tax take home dollars, but there are many tax benefits to the Roth option.
As stated earlier, the traditional 401(k)/457 is funded using pretax dollars. You pay your taxes on your investments when you make withdrawals upon retirement. For instance, if you invest $100,000 during your working years (pretax) and it grows to $300,000, you will pay taxes on each dollar of the $300,000 as you draw from it and you will be taxed at the current tax bracket you are in. The government will get their money, but it is deferred until you draw from it.
The Roth IRA
The Roth IRA is unique in that you pay taxes on the front end but not the back. For instance, if you invest $100,000 of your after-tax dollars during your working years you would have paid the government the taxes on that $100,000 while you were working. If that investment grows to $300,000; a gain of $200,000 in interest, you will be able to pull this money out of your Roth tax-free! The government does not make any money off of the gains in a Roth like they do on 401(k)/457 gains.
Contribution Limits (2019)
The Traditional 401(k)/457
For 2019, the contribution limit to the 401(k)/457 is $19,000. This means you are able to defer a maximum of $19,000 of your pretax money into a 401(k)/457 in 2019. While you are limited in your 401(k), this does not preclude you from investing in other retirement vehicles as well – such as a Roth IRA.
The 401(k)/457 Catch Up
If you are age 50 or older, the IRS allows for you to contribute an additional $6,000 a year to your 401(k)/457 for a total of $25,000 pretax dollars. This is known as the catch-up contribution limit and employer-sponsored matches are not included in this total.
The Roth IRA
For 2019, the contribution limit to a Roth IRA is $6,000. This means you are able to invest $6,000 of your after-tax money into a Roth IRA. While this amount is small compared to a 401(k), this does not preclude you from investing in other retirement vehicles as well – such as a 401(k). (Couples may contribute $12,000 a year to a Roth)
The Roth IRA Catch Up
If you are age 50 or older, the IRS allows for you to contribute an additional $1,000 a year to your Roth IRA for a total of $7,000 a year.
The Back Door Roth
If you make too much income, you may be excluded from investing in a Roth IRA. Fortunately, there is a loophole in the system and a way to convert some of your traditional IRA dollars into Roth IRA money. Check out this related article on Back Door Roths!
Income Limits To Investing
If you make too much money, the government will exclude you from being able to invest in certain retirement vehicles. Here is the most you can make before you are no longer allowed to invest in these vehicles.
No limit, hurray!
The Roth IRA
If you are single, you may only contribute money to a Roth IRA if you make less than $122,000 a year. If you are married filing jointly, you may only contribute to a Roth IRA if you make less than $193,000 combined (2019).
Breaking Down The Tax Benefits
The main benefit to the 401(k)/457 plans is the ability to significantly lower your tax liability in your working years. Whatever amount you contribute to these plans lowers your income levels by that amount and it may significantly impact your taxes. The ability to lower your income levels to a lower tax bracket through investments is a great tactic to discuss with your tax professional!
These plans make sense if you expect your taxes to be lower in retirement. Rather than being taxed at a higher amount during your employed years, paying taxes on your money at a lower rate in retirement may be the right choice for you!
The main benefit to the Roth IRA is the ability to grow your investments tax-free. If you expect that your current tax bracket will be higher in retirement than it is now, a Roth may be right for you! The fact that you can grow your investments and not pay taxes on them is a great reason to invest in a Roth IRA!
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With a traditional 401(k)/457 plan sponsored by your employer, you are limited in your investment choices. You are given a limited number of funds to invest in, based on your employer and retirement plan sponsors choice of funds they make available to you.
With a Roth IRA, you can take control of your investments and choose the funds you feel will most benefit you. You are not limited by your employer’s investment options and are free to invest in your chosen strategy.
The Bottom Line
The truth is, both of these options are great options for retirement. The fact that the majority of Americans do not save enough for retirement, offers a bleak look into our future. Each investment vehicle offers different benefits, but if you invest significantly in either, you are doing better than the majority of the population.
The only negative with the Roth IRA is the contribution limitations. $6,000 is not a lot of money to invest each year so if you choose the Roth option, I would strongly encourage you to find another investment vehicle to contribute additional money.
Do you use a Roth, 401(k)/457 or both? If you have used either, you know how easy it is to set up automatic payments to get your investments on the right track. If you have yet to start after destroying your debt, I would encourage you to look into your retirement options available to you.
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