Building Wealth: 401(k) vs. Roth IRA

How old are you? Do you earn a monthly income? Do you know the difference between a 401k vs. Roth IRA?  The average American will {hopefully} contribute to one or the other or perhaps even both in their lifetime. I have one of each for myself, for different reasons and I’ll tell you why.

Let me tell you a story first: After my grandfather returned home from his service in WWII and the Korean War, he worked the remainder of his life in a cement factory – a cement factory that offered a pension plan. He passed away young and when he did, he left my grandmother that sizable monthly pension that she then used in addition to her social security. No retirement account to speak of.

After raising eight children as a stay-at-home mother (homemaker in those days!) with the last of my uncles leaving home when she was around sixty-three years of age, my grandmother simply could not have enjoyed her comfortable lifestyle without my grandfather’s pension – that she received monthly for over 20 years after his death in the late 80’s.

Before we get into the specifics of each of these retirements plans, it is important to realize that work pensions are quickly becoming a thing of the past.  If you’re wanting to retire – and before the age of 75 – you are going to have to plan for this yourself.

Do not rely on your possible inheritance, do not rely on your employer (although if they match your contribution you definitely want to capitalize on that – more on that later), do not rely on Social Security, do not rely on anyone or anything but yourself.  Even if you are “only” twenty-five years old, NOW is the time to start – you’re in this for YOU and you’re in it for the long haul. You’ll thank yourself later.

Before deciding whether to go with a Roth IRA (Individual Retirement Account) or a 401(k), you’ll want to ask yourself two basic questions:

1. Will my employer match any contributions that I make?
2. Do I want to pay taxes NOW or LATER?

You’re going to either pay your taxes before you contribute to the retirement account plan or you’re going to pay when you withdraw your funds (a.k.a. when you retire).  Uncle Sam will get his portion here or there.  Which route will you take?

What is a Roth IRA?

A Roth IRA is an Individual Retirement Account that you set up directly with an investment firm.  You tell them how aggressively you want them to invest your money. Whether you are on the conservative side, moderate or you are aggressive with investing your funds is completely up to you.

With a Roth, you’ll make your contributions after taxes are taken out of your income – ie: straight from your own pocket/checking account after depositing your paycheck.  When you reach age 59 1/2 and you have had your Roth IRA for at least five years, you can then withdraw your funds (both investment gains and deposits) completely tax free – because you had already paid taxes on that income when you received your paycheck way back when.

Ask yourself: do I see myself in a much higher tax bracket (more income) when I retire than I am currently?

Example: If you are 25 years old and sitting in the 15% tax bracket now, by the time you retire are you expecting to be in the 25% or higher tax bracket? If so, you could be paying considerably more in taxes when you withdraw your funds than you would if you paid in taxes now.

There is also a maximum amount you can contribute per year to your Roth IRA ($5,500 in 2016 for those under age 50) with a few exceptions.  You’re going to want to visit with your financial adviser for more detailed information but suffice it to say that unless you are contributing more than $450 (ish) per month (go you!) you don’t have much to worry about.

A bonus to a Roth IRA is that you get to pick with whom you work.  You pick the firm, the representative.  You may also retrieve any of your contributions (not investment earnings, contributions only) at any time without being penalized.

What is a 401(k)?

A 401(k) is a retirement account offered through your place of employment.  This is typically offered as a group benefit, so you are going through the investment/brokerage firm of your employer’s choosing. You will have options within the plan just as you do in a Roth, except that when your employer cuts your paycheck, they take the funds out before income tax and send them to be deposited into your personal plan.

Start with $25 or $50 per paycheck – or as much as you can manage.  The point is that you’re doing it. Small amounts add up to big amounts, especially if you are young and have another 30-40 years of work (contributing) before you.

Since they take it out pre-tax, the amount that this affects your paycheck is less than you might think.  If you have them withhold $50 per paycheck, that may only feel like $40 when all is said and done.  Again, just an example but you get the idea.

If your employer offers to match your contribution, some match 3%, some 5%, some 6% (the higher the better!) and you are not contributing, you are turning down (think: wasting) free money by not taking advantage of this benefit.

If your EMPLOYER will match your contribution up to 5% of your gross salary, and YOU are contributing 5% of your gross salary, that is 10% of every month’s gross (pre-tax) earnings going straight into your 401(k).

Example: let’s say your pay checks are $1,500 gross (before taxes) every two weeks. That is $3,000 gross (before taxes) per month, your 5% contribution would be $150 and if your employer matches up to 5%, they are also adding $150 to your $150. This means that $300 per month is being deposited into your 401(k) account. Keep in mind that this only feels like $125 (huge estimation here) since you are not taxed on this income yet. You get the drift.

When you reach retirement age, and you go to withdraw your funds, you will then pay tax on that money – at your retirement-age tax rate.

A bonus to the 401(k) instead of Roth is that you could get a tax break during the year that you contribute, each and every year.  While there is a limit to how much you can contribute each year as well ($18,000 in 2016), you are allowed to make much higher contributions to a 401(k) vs. a Roth (about three times as much!).

There are many options and restrictions to consider when choosing a Roth IRA vs. 401 (k), so you’ll definitely want to visit with your financial adviser before making any final decisions or setting up an account.

Which should you go with?

I have my Roth account to deposit small amounts throughout the year and to deposit into if needed for tax purposes, and my 401(k) through my employer to take advantage of their match.

No matter which option you choose, the point is that you are doing it.  You are planning for your future, you’re being an adult about it, and you’re ultimately going to retire young(er) as a result.  Go you!