When it comes to retirement savings, many people are faced with the decision of whether to invest in a Roth IRA or a 401(k) plan. While both offer tax advantages, there are some key differences between the two that can make one a better option than the other. A Roth IRA is an individual retirement account that allows workers to save for retirement outside of an employer-sponsored plan. Contributions to a Roth IRA are made after tax, meaning they don't reduce your taxable income in the current year.
This can be beneficial if you expect to be in a higher tax bracket in retirement, as you can pay taxes now while your tax rate is lower and then enjoy tax-free withdrawals while your tax rate is higher in retirement. In addition, a Roth IRA offers more flexibility and control over your investments than a 401(k). With a Roth IRA, you can choose from the entire investment universe, including stocks, bonds and individual funds. In contrast, with a 401(k) plan, you are limited to the funds offered by your employer plan.
Another benefit of the Roth IRA is that the account can essentially exist forever with no minimum distributions required. If the account holder dies, the spouse who inherits the Roth IRA will not have to accept distributions or pay taxes. On the other hand, there are some advantages to investing in a 401(k) plan over a Roth IRA. For one, there are no income limits on a Roth 401(k), so it can be beneficial for older, higher-earning employees to reap the benefits of tax-free withdrawals later.
Additionally, contributions to a traditional 401(k) plan are made with pre-tax money, so you get an upfront tax cut which helps lower your current income tax bill. Finally, if you can't deduct your traditional IRA contributions anyway, contributing to a traditional or 401(k) IRA can result in a lower adjusted gross income (AGI) because your pre-tax contributions are deducted from that figure. Ultimately, both 401(k) and Roth IRAs are popular retirement savings accounts with tax advantages that differ in tax treatment, investment options and employer contributions. However, regardless of which fund (or funds) you choose, investment gains made within the plan are not taxable by the Internal Revenue Service (IRS) until the funds are withdrawn (whereas Roth IRAs never pay taxes, even on retirement).
Again, the tax deferral benefit of a business-sponsored plan is a good reason to allocate money to a 401(k) after you've funded a traditional or Roth IRA.