401(k) vs. Roth IRA: What's the Difference?

401(k) and Roth IRAs are investment accounts that people contribute to for retirement savings. Each account has pros and cons that people must consider before making a retirement investment. Focus on researching available options and choosing a plan to help your money grow toward retirement goals.

Americans have?about $141,542?saved for retirement on average. However, the reality is that most people have much less – the median 401(k) balance, for instance, is only $35,345.?

The issue is retirement savings are essential for ensuring a worker has enough money to enjoy a quality standard of living during retirement. It takes time to grow a retirement nest egg that will last through those golden years.?

Anyone can start saving for retirement at any point. And if you’re not investing much money now, you can easily update your strategy. So, the only question is whether to put those retirement savings in a 401(k) plan or a Roth IRA plan.

401(k) and? Roth IRA retirement plans offer many benefits, but they depend on various factors, such as income levels, employer matching and tax benefits. This article will show you the differences between these account options and help narrow which makes sense for your financial future.

What is a 401(k)?

A 401(k) plan is a retirement savings plan that many employers offer in the U.S. Employees participating in this plan will agree to a percentage of their paycheck directly deposited (pre-tax) into the account.?

There are two types of 401(k) plans: traditional and Roth. A traditional 401(k) means employee contributions come from gross income. With a Roth 401(k), contributions come from after-tax income.?

Usually, employers are more likely to offer traditional 401(k) plans over Roth 401(k) plans, but if both options are available, employees may choose one or a mix of both.?

Contribution Limit

There is a maximum amount that employees and employers may contribute to 401(k) plans each year. In 2023, the annual limit for employee contributions will be?$22,500 for those under 50. For workers over 50 years old, the IRS will increase the?catch-up contribution?in 2023 to $7,500 to go on top of the other savings.

Distributions

Since 401(k) plans help people save for retirement, there are rules in place that help encourage people to save for longer periods rather than take distributions. One rule is that people usually incur a 10% early distribution penalty fee if they withdraw funds before 59?.

Additionally, the IRS requires distributions after a certain point. Required minimum distributions (RMDs) are mandatory amounts that plan owners must withdraw each year starting in April of the year after they turn 72. This ensures people don’t use their retirement accounts to avoid paying taxes on those funds. Still, some plans allow participants to defer RMDs until they retire (even if they are older than 72).

Income Limit

401(k)s don’t have contribution limits based on income, but an employer’s match might have limits if the employee makes over $330,000 in 2023. Employers may only match up to that $330,000 salary, so if an employee earns more than this, they cannot raise their match to meet that higher salary level.?

Employer Matching

Employers may use various formulas to match employee contributions. And typically, an employer may choose?a partial or full match.

A common partial match example is 50% of what the employee puts in, up to 6% of their salary. Another example of a standard full match that a company may offer would be a 100% match up to 3% of the employee’s salary.

What is a Roth IRA?

A Roth IRA is an investment account with special tax advantages many people use for retirement savings. The main benefit of this account is that the account holder pays taxes on the money as it goes into the Roth IRA, but there are no taxes from future withdrawals.?

People may choose to open a Roth IRA through many financial institutions, such as:

• Brokerage firms.
• Investment companies.
• Banks.

Some employers may facilitate IRA contributions through their employer-sponsored retirement savings plan. This allows employees to contribute to this account type directly from their paychecks.?

Still, this does not mean that the plan comes from the employer-sponsored savings plan itself, as the account owner (the employee) must manage it. Since this can become complex, Roth IRA holders with higher incomes may choose to pay a financial expert to manage their accounts.

Contribution Limit

In 2023, eligible plan participants can contribute up to $6,500 to their Roth IRAs. If the plan participant is over 50, they may contribute up to $7,500.?

To contribute to a Roth IRA, people must have earned taxable income within IRS limits. This would include money from:

• Wages or salaries.
• Bonuses.
• Business earnings (for the self-employed).
• Alimony.
• Child support.?
• Combat pay.

Distributions

Account holders can withdraw funds from their Roth IRA whenever they want because they’ve already paid taxes on those funds. The only exception relates to the account's earnings (or interest), which was not part of past contributions.

Taking a distribution that includes an account’s earnings is a qualified distribution. To take a?qualified distribution, the account must be?at least five years old, and the account holder must be 59? or older.?

However, if the account holder is not yet 59?, there are exceptions to these rules that allow someone to avoid the 10% early withdrawal penalty (but still pay taxes) on a distribution. The following circumstances may help to?avoid these additional fees:

• The distribution goes toward qualified education expenses.
• The account holder uses the funds for expenses related to birth or adoption.
• The account holder developed a permanent disability before the distribution.
• The distribution will go toward purchasing a first home (at a limit of $10,000 per lifetime).?
• The distribution is for the beneficiary or estate of the Roth IRA holder after death.?
• The distribution pays for unreimbursed medical expenses or health insurance after unemployment.?

Income Limit

There are strict income limits with a Roth IRA. Typically, the higher their income, the less they may contribute within a year.

The IRS has a helpful chart?that shows how much account holders would be eligible to contribute based on the following:

• Tax filing status.
• Modified?adjusted gross income?(AGI)

Employer Matching

There is no employer match with a Roth IRA since an employer’s program does not sponsor it. Although this means employees won’t receive these additional funds in their accounts, a Roth IRA may still be the right account for someone wanting to save, depending on other factors.??

Final Thoughts on Choosing a 401(k) or a Roth IRA

There are benefits and drawbacks to choosing a 401(k) plan or a Roth IRA. However, everyone has a unique financial situation, so determining which option is more beneficial through research will help you make a wiser decision.?

A 401(k) may be a better option if:

• Your pay is too high to contribute to a Roth IRA.
• You’d like to save more money yearly.
• Your employer offers a 401(k) match.

A Roth IRA may be the best choice if:

• You’d like more tax benefits.
• You desire more investment opportunities.?

If you’re ever unsure about the right plan option (or if both options are?manageable simultaneously), speak with an experienced financial planner or advisor to help develop a plan that works for your current and potential finances.

Top Takeaways

401(k) vs. Roth IRA: what’s the difference?

• While 401(k)s and Roth IRAs help people save for retirement, there are many differences in how the IRS treats these investment accounts.
• Depending on income, saving goals, and desired distribution ability, one option is likely more appropriate for most individuals.?
• Looking at a 401(k) vs. a Roth IRA shows us that researching retirement planning options based on your current financial status is the best decision.

(Reporting by NPD)