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"I'm having trouble understanding the difference between a 401(k) and a Roth IRA -- do I need to have both of these or can I get by in retirement with just one? Thanks!"
The discovering the difference between a 401(k) and a Roth IRA is not nearly as complicated as it sounds. Whether or not you really need both depends on a few different things, namely tax considerations -- what your marginal income tax bracket is now and what you expect it to be in the future (namely at retirement).
Ultimately, this is what boils down to the difference in these two plans - tax treatment, investment options available and possible employer contributions. You can have BOTH accounts and contribute to each, however, not with the same money.
Named after section 401(k) of the Internal Revenue Code, a 401(k) is an employer-sponsored deferred income plan. To contribute to a 401(k), the employee designates a portion of each paycheck to be diverted into the plan. These contributions occur before income taxes are deducted from the paycheck.
The fund investments are made available by the plan provider. The investment options among different 401(k) plans can vary tremendously. Any investment gains realized within the plan are not taxed by the IRS. Taxation only occurs after the employee has reached retirement age and begins to take withdrawals, at which time the funds are subject to income taxes.
As of 2017, the limit for annual 401(k) contributions is $18,000 for those under the age of 50. Those ages 50 and older can contribute an additional $6,000 per year.
401(k) plans are most beneficial when an employer offers to match by contributing additional money to the employee's 401(k) based on how much the employee contributes. This is a form of additional deferred income, and it does not count towards the standard annual contribution limits.
A variation of traditional individual retirement accounts, a Roth IRA is set up directly between an individual and an investment firm; the individual's employer is not involved. As there is no employer, there is no opportunity for an employer match with Roth IRAs. Unlike non-Roth retirement accounts, after-tax money is used to fund a Roth IRA. Any investment growth is still untaxed, and no income taxes are levied on withdrawals during retirement.
Since the account is set up and controlled by the account owner, investment choices are not limited to what is made available by a plan provider. This gives IRA accounts a greater degree of investment freedom than employees have with their 401(k)s.
The contribution limits are much smaller with Roth IRA accounts. In 2017, the maximum annual contribution is $5,500 for those under the age of 50, while those ages 50 and up can contribute an additional $1,000 for a total of $6,500 per year. Individuals who earn more than $133,000 per year (or $196,000 for couples) are ineligible to contribute to a Roth IRA.
Roth accounts make the most sense for individuals who believe that they will be in a higher income tax bracket when they retire than they are currently in today. This is because it is ideal to pay a smaller percentage on your income prior to contributing (as in a Roth IRA) than to pay a larger percentage of taxes on withdrawals (as in a traditional IRA).
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