Roth IRA, 401(k) Plan, or Both?
Oct 24, 2013
Roth individual retirement accounts (IRAs) and 401(k) plans both offer advantages for retirement savings, so you may wonder which you should choose. Before deciding, let’s look at some of the advantages of each.
The Advantages of a Roth IRA
- While your contribution is not tax deductible, your contributions and earnings grow on a tax-free basis. You can withdraw those funds without paying any federal income taxes, as long as the distribution is qualified. A qualified distribution is one made at least five years after the first contribution and after age 59 1/2.
- You choose which investments to use for your IRA. You are allowed to invest in a broadrange of investment alternatives. With a 401(k) plan, you are limited to the investment options offered by your employer.
- You can withdraw your contributions at any time without paying any federal income taxes or the 10 percent federal penalty.
- You are not required to make withdrawals from a Roth IRA, even after age 70 1/2. Thus, it can be a good tax-advantaged way to accumulate funds for heirs.
The Advantages of a 401(k) Plan
- Contributions are typically made on a pre-tax basis, so you don’t pay current income taxes on your contributions.
- Your earnings grow and compound on a tax-deferred basis until you make withdrawals from the plan.
- Larger contributions are allowed to 401(k) plans.
- Many employers match a portion of your 401(k) contributions, effectively increasing your savings rate.
Deciding Between the Two
Typically, the best strategy is:
- First, contribute enough to your 401(k) plan to take full advantage of your employer’s matching contributions. This is free money that you give up when you don’t contribute.
- Next, contribute up to $5,500 to a Roth IRA for 2013 (up from $5,000 in 2012) provided you are eligible to make a contribution. Taxpayers 50 and older can also make catch up contributions of $1,000 (same in 2012). Single taxpayers with adjusted gross income (AGI) of less than $112,000 and married taxpayers filing jointly with AGI of less than $178,000 can make contributions (up from $110,000 and $173,000 in 2012) .
- Next, contribute any additional retirement money to your company’s 401(k) plan. You can contribute a maximum of $17,500 for 2013 (up from $17,000 in 2012) unless your employer sets a lower limit to comply with government nondiscrimination regulations. If you are age 50 or older and your plan permits, you can make an additional $5,500 catch-up contribution (unchanged from 2012) bringing your maximum contribution to $23,000.
- Finally, consider other alternatives for any other savings you would like to earmark for retirement. That could include taxable investments and annuities.