When it comes to retirement savings, there is no one-size-fits-all answer as to which is better, a Roth 401(k) or a Roth Individual Retirement Account (IRA). Both have their own set of benefits and drawbacks, and it's important to understand the differences between them before deciding which one is right for you. Contributions to a 401(k) are pre-tax, meaning they reduce your income before your taxes are withdrawn from your paycheck. Conversely, there is no tax deduction for contributions to a Roth IRA, but contributions can be withdrawn tax-free during retirement.
A Roth IRA is better for taxpayers who expect to be in a higher tax bracket in retirement. You can pay taxes today while your tax rate is lower, and then enjoy tax-free withdrawals while your tax rate is higher in retirement. Roth IRAs offer investors much greater control over their accounts than a Roth 401(k). With a Roth IRA, investors can choose from the entire investment universe, including stocks, bonds and individual funds.
In a 401(k) plan, they are limited to the funds offered by their employer plan. With a traditional 401(k), you make contributions with pre-tax money, so you get an upfront tax cut, but withdrawals are considered ordinary income and you have to pay taxes at your current rate; there may also be state taxes. With a Roth IRA, money grows tax-free and you can withdraw your contributions at any time without penalty. A Roth IRA also allows more flexibility with distributions than a Roth 401(k). With certain exceptions, you can withdraw income from your Roth IRA without penalty if you have maintained the account for less than five years, and without penalties or taxes if you have maintained it for more than five years.
However, with a Roth 401(k), you must begin taking the required minimum distributions (RMD) once you turn 72. One benefit of the Roth IRA is that the account can essentially exist forever with no minimum distributions required. And if you have a relatively modest income, that lower gross income can help you maximize the amount you receive from the saver's tax credit, which is available to eligible taxpayers who contribute to an employer-sponsored retirement plan or a Roth or traditional IRA. In the end, it's important to consider your individual financial situation when deciding which type of retirement account is best for you. If you're thinking about starting to save for retirement, chances are you're considering Roth IRAs and 401(k) plans. Consider all of the factors involved before making your decision.