Guest Post: The Roth IRA vs The 401k Battle- Which Reigns Supreme?
From new initiatives to changing economies, retirement and retirement plans seem to be the topic of discussion these days. What’s your plan? Are you satisfied with it? Do you think that you may benefit from entering into a different option, but are weary of the change? If you’ve questioned your retirement plan, good for you- it’s great to stay on top of your money and where it goes, especially when it can come back in the future to help you. However, questioning your current situation while failing to take further action is futile. At the same time, changing your retirement plan on impulse could come back to haunt you. Thus, it’s most important to first know your choices, consider your situation, and then make an educated decision. Here, we take you along the first step and study two retirement options- the traditional 401k plan versus the roth IRA plan, investigating their benefits, setbacks, similarities, and differences.
The 411 on the Traditional 401k
The traditional 401k is the most typically known retirement plan. The 401k has been offered from corporations to employees since 1980, and ultimately allows individuals to set aside a portion of wages (contributions) to a tax-deferred account for safekeeping and retirement plans. Keep in mind that the traditional 401k account is funded with pre-tax dollars, and thus earnings must be taxed when they are eventually withdrawn. In certain cases, an employer may opt to “match” some or all of an employee’s contribution and an individual must take distributions at age 70.5 from the account.
- The Pros
- Company Sponsored: Typical 401K accounts are company sponsored. Many employers also opt to match a certain percentage of contributions made to the company sponsored plan.
- Pay taxes on withdrawals: Because upon retirement there is a possibility that you will be in a lower tax bracket than the year contributions were made, the 401K could be more beneficial than a Roth IRA assuming investment returns are the same.
- No income limits: No matter how much money you make, you can contribute to a 401K. Individuals in the high income brackets are not allowed to make contributions to a Roth IRA.
- Annual Contribution amount: For 2010 the maximum contribution amount is $16,500, which is greater than the annual contribution amount allowed for a Roth IRA.
- Reduces taxable income: Whatever amount you contribute to your 401K will reduce your taxable income by that amount for the year that the contribution was made.
- The Cons
- Forced Withdrawals: It is required that withdrawals must be taken at a certain age. Many investors argue that the forced withdrawal of massive amounts through 401K plans can cause the markets to severely drop due to the large amounts of capital leaving the market for the reason that individuals are required to sell, not because the value of the company dropped- which is artificial deflation of the stock’s value.
- Employer Choice of Funds: Many companies will offer several fund options that are funds of their choice. This limits the flexibility of investments made through a 401K.
- Pay taxes on withdrawals: While one of the main benefits of a 401K is that you defer paying taxes on the contributions until retirement, the taxation environment is unknown for the future. Tax rates have a tendency to increase, not decrease; so there is a possibility that higher tax rates will have to be paid on your funds.
- Early Withdrawal Penalties: When it comes to taking early withdrawals from your 401K account, there are many more penalties associated with the action as opposed withdrawing from a Roth IRA investment account.
The Real Deal on the Roth IRA
The Roth IRA, or Individual Retirement Account, option was created in 1997, and serves as an alternative plan to the traditional 401k. In this case, contributions are treated differently. With the Roth plan, contributions are considered to be after-tax dollars, and thus taxes must be paid the same year in which they are submitted into the account. Keeping this in mind, the money that may grow over time in the account will be tax free money. The Roth IRA can be opened by most individuals that meet standard criteria and does not require an individual to take distributions at any point (thus, money can be transferred to heirs).
- The Pros
- Avoid Early Distribution Penalties: There are not as many limitations on taking early distributions as there are with 401Ks. The Roth IRA has many exceptions that allow funds with be withdrawn without penalty.
- No Age Requirement to make Withdrawals: You are not required to make withdrawals at a given age like you are with a 401K. This allows you to keep money in your investments and earning gains (or losses). Money can remain in the account for its beneficiaries as well.
- 2010 is a special year: There are special conversion rules that apply this year making this form of retirement account available to more individuals. For 2010 the adjusted gross income level for making conversions to a Roth IRA do not exist, taxes are not due in 2010 (can be deferred until 2011 or 2012), and conversions can be made from 401Ks and traditional IRAs.
- Flexibility in investments: With a Roth IRA, you can invest in a much wider variety of investments as compared to a 401K.
- The Cons
- Income limits: Contributions made to a Roth IRA are restricted to individuals and couples with an adjusted gross income of $120,000 and $176,000, respectively. If you make too much money to contribute to a Roth IRA and you have another existing retirement account, 2010 is a special year and the IRS has special conversion rules for converting other forms of retirement accounts to a Roth IRA.
- Annual Contribution Amount: For 2010 the maximum contribution is $5,000, or $6,000 if you are older than 50 years old before 2011. This amount is significantly less than the amount allowed when making investments towards a 401K
- Investments made after tax: Since investments are made after tax there is a possibility that your tax rate will be higher at the time of your investment than if you were to defer paying taxes until retirement thorough a 401K.
Still Unsure? The Main Differences Breakdown
- Withdrawal Timing: If the timing of your distributions is important to you then it is essential to consider this difference. There are fewer restrictions on taking distributions through a Roth IRA than a 401K. With a 401K, there are forced withdrawals at the age of 70.5, while with a Roth IRA, the funds can remain in the account.
- Employer Match: Typically most companies that offer a 401k also match a certain percentage of contributions made. In the case where a company match is made, it is a no brainer that a 401K should be used for at least the amount that the company is willing to match vs. investing the same money in a Roth IRA that has no match.
- Income limits: Since the Roth IRA has income limits associated with making contributions, it may not be available to all individuals.
- Contribution Amounts: There are different limits to the maximum amount of money that can be contributed to each type of account every year. A 401k allows for a higher contribution amount than a Roth IRA.
- Anticipated future tax rates: The IRS can either increase or decrease tax rates in the future (most likely increase) or you can be in a higher or lower tax bracket at retirement. Taking into account your tax rate when making your investment contributions and what your anticipated tax rate will be in retirement can determine which retirement alternative reigns superior (all else held equal).
- Investment Options: 401K plans are limited in investment options, while a Roth IRA allows for a much wider variety of investment options. You must ask yourself if you are the investor type and want to have full control of where your investments are going.
Make up your Mind
Now that you have adequately learned about the Roth IRA and 401k plans, it’s time to make a decision. If you are still in your youth, now may be a great time to make the choice as you enter into your first job. If you have already entered into a retirement plan, it’s always a good idea to reconsider your choice with regards to the most practical option for you. Just because you have started on one retirement plan does not mean that you have to stay put. However, keep in mind that the earlier you begin planning and setting aside money to the proper account, the more work it can do for you. So consult with yourself, your friends, your employer, and your tax advisor to find your best option. And, hey, know that you can always decide to contribute to both types of accounts! Just remember, life is all about change- and making the decision to change your retirement plan could impact both you and your heirs’ lives forever.