The confusion between 401(k)’s and Roth IRAs stems from the fact that they’re both tax-advantaged retirement plans. They differ in secondary factors like tax treatment, investment option, and employer contributions. Most people get confusing advice on these plans and often think that they have to pick one or the other. In an ideal scenario you would have both in which to put funds away for retirement, but if you’re wondering where to start, keep reading below:
A Roth IRA is an individual retirement account that lets you grow your money tax-free while it is in the account. Additionally, as long as you’ve owned the account for five years and you’re age 59 ½ or older, you can withdraw money when you want without paying federal taxes.
401(k)s were introduced in the 1980s as a way to supplement pensions. Essentially, a 401(k) is an employer-sponsored retirement savings plan. Employees are allowed to save and invest a piece of their paycheck before taxes are taken out, and some employers match a percentage of the amount that the employee puts into the 401(k) plan. Taxes aren’t paid until the money is withdrawn from the account.
It might also be useful to know that there is another IRA that often gets confused with Roth IRAs. Roth IRAs differ from traditional IRAs in several ways:
When considering which investment vehicle will work best for your retirement, remember that you might not even have the option of investing in a 401(k) plan or Roth IRA. Here’s a quick guideline on whether or not you’re eligible:
For Roth IRAs:
Absolutely. The first thing you should check is if your employer offers a 401(k) match. If they do, you should begin by taking advantage of the match by contributing at least that much to your 401(k) plan at work. For example, if your employer provides a 3% match, you should aim to contribute at least 3% of your salary into the plan as well. Once you do this and have enough to contribute to more retirement savings every month, you can either increase your 401(k) contribution percentage or start contributing to a Roth IRA.
Remember, you should not invest your emergency fund or any money you’ll need in less than 5 years.
So which is best for your finances: Roth IRA or 401(k)? This is often a false choice because the answer is both! Ultimately, the differences lie in the types of tax advantages that you can get between the two plans.
We would recommend starting with the one thing you know for sure: it’s smart to take advantage of your employer’s 401(k) contributions, so contribute at least enough to fully utilize the match if that’s available to you. If your employer doesn’t offer a 401(k) at all, then investing in a Roth IRA can be incredibly powerful for retirement planning.
Still, everyone’s financial situation is different and your choice can be impacted by factors like your spouse’s income, any inheritances, or other tax needs. Because these accounts are so critical to your tax liability, it can be helpful to speak to a tax planner or tax attorney if you believe your circumstances need further discussion.