What Is a Roth IRA?
A Roth IRA is an individual retirement account available to self-employed individuals.
Contributions made to a Roth IRA are funded with after-tax money, not deductible from your income.
Roth IRAs offer tax-free growth and tax-free withdrawals if certain conditions are met.
Important Features of a Roth IRA
Below are some of the distinct features of a Roth IRA:
Contribution Limit
The contribution limit set for Roth IRAs in 2022 are $6,000 for holders below 50 years of age and $7,000 for holders aged 50 and above; the limit includes the catch-up contribution of $1,000.
Whereas, the limit for 2023 are $6,500 for holders below 50 years of age and $7,500 for holders aged 50 and above.
Income Limit
The table below shows the income limit for Roth IRA contributions for the years 2022 and 2023:
Withdrawals
Withdrawals from Roth IRA contributions are without tax and penalty at any time or age.
However, withdrawals on the account’s earnings are subject to income tax and an early withdrawal penalty of 10%, depending on the holder's age.
In general, taxes and penalties may be avoided given the five-year-old rule is followed and the withdrawal made meets the following:
- Withdrawal is made after 59.5 years old
- Reason for withdrawal is due to permanent disability or used to purchase or rebuild a house
- The beneficiary or estate makes a withdrawal after the owner's death
Required Minimum Distribution
Roth IRAs do not have required minimum distribution (RMD) rules like 401(k) accounts.
This means the holder will not be forced to withdraw from the account when 73 years old.
Thus, the money on the account can grow tax-free for as long as the owner keeps the account open.
Investment Options
Roth IRA holders can invest in almost any type of investment ranging from stocks, bonds, exchange-traded funds (ETFs), real estate investment trusts (REITs), and certificates of deposit (CDs).
Pros and Cons of a Roth IRA
Some of the advantages of a Roth IRA include tax-free withdrawals, flexible investment choices, and no required minimum distribution rule.
Due to the tax-free nature of the withdrawals and flexibility in investments, a Roth IRA may be used as an estate planning tool.
A disadvantage of a Roth IRA is that it does not offer any employer-sponsored match like what you can get from your 401(k). There are no employer matching contributions available for Roth IRA holders.
Roth IRA holders are also limited to lower contribution limits and certain income limits.
What Is a 401(k) Plan?
A 401(k) is an employer-sponsored plan that allows employees to make pre-tax salary deferrals into individual accounts.
The money is invested on the employees' behalf, often by the company's investment staff or through mutual funds selected by the company, and grows on a tax-deferred basis.
Important Features of a 401(k) Plan
Below are some of the distinct features of a 401(k) plan:
Contribution Limits
For the year 2023, contribution limits for 401(k) accounts are set as follows:
- $22,500 for holders under the age of 50
- $30,000 for holders age 50 and above; limit includes catch-up contribution of $7,500
Employer Match
Although not mandatory, employers have the option to match the contributions made by their employees.
This match may come as a dollar amount, a percentage of the employee's salary, or a percentage of the contribution made by the employee to the 401(k) plan.
The match made by the employer is not included in the employee's contribution limit.
Instead, a separate combined contribution limit for 2023 is set by the IRS as follows:
- $66,000 in total contribution (employee and employer) for ages below 50
- $73,500 for age 50 and above, inclusive of a catch-up contribution allowance of $7,500
- 100% of the employee's salary if it is less than the dollar limits
Taxes
Contributions made to a 401(k) plan are tax-deferred.
Your contributions are deducted from your taxable income, so you will not pay taxes on the amount during that year.
Investments grow on a tax-deferred basis until withdrawals are made. Taxation will only be taken when you withdraw from the account and not while it is still in your account.
Required Minimum Distribution
As soon as you turn 73 years old, you are required to take out a minimum yearly distribution from your 401(k) account.
This is known as RMD or Required Minimum Distribution, and failure to do so may result in penalty fees for you.
Investment Options
401(k) plans have fewer investment options because it is usually managed by the company or organization that offers them. There are also sustainable 401(k) plans and portfolios for employers who want to provide the option to invest in climate-friendly portfolios.
Pros and Cons of a 401(k) Plan
A 401(k) plan has many advantages, such as employer matching contributions up to a certain percentage, pre-tax contributions, deferral until withdrawal, higher contribution limits, and the convenience of the plan being maintained by the employer.
However, some of its disadvantages are required minimum distributions, fewer investment options, and higher fees. Use the 401(k) comparison tool to understand the best provider for your company.
Roth IRA vs. 401(k): Which One Should I Choose?
A Roth IRA and a 401(k) plan have pros and cons, but deciding which to put your money in will depend on your personal preference.
If you are satisfied with the limited number of investment options with a 401(k), this may be better. If you prefer to invest in more varied assets or contributions from your employer, a Roth IRA could give you better results.
All retirement plans currently have higher contribution limits than a Roth or traditional IRA, so it is important to check out what they can offer you before deciding between a Roth IRA vs. 401(k).
FAQs
1. What is an employer-sponsored plan?
An employer-sponsored plan is a formal program that offers benefits such as retirement plans, health insurance, and other programs necessary for the smooth operation of the business.
2. What is a 401(k) plan?
A 401(k) plan is an employer-sponsored plan in which employees can make contributions with pre-tax dollars from their paycheck towards their retirement fund. The company either selects funds, or the company's investment staff manages investments on the employee's behalf. It grows on a tax-deferred basis until withdrawal is made.
3. When is a Roth IRA a better choice over a 401(k) plan?
A Roth IRA is a better choice over a 401(k) plan when you want greater control over the investment options, lower fees, and tax-free growth.
4. What does tax-deferred growth potential mean?
Tax-deferred growth potential is the benefit of a 401(k) plan in which contributions and earnings made in a tax year are not taxed until withdrawal.
5. What is the disadvantage if my employer does not contribute to my 401(k) plan?
The disadvantage of not receiving an employer contribution to your 401(k) plan is that you will be missing out on the chance for additional growth you would have been entitled to receive from a company match.
