Roth IRA Vs. 401K: Which Is Right For Me?

Deciding the best way to save for retirement can be confusing. Many investment options seem remarkably similar and trying to understand the differences feel like trying to decipher the Rosetta Stone. 

Choosing between the different types of retirement plans can be stressful when you’re a self-employed real estate investor, especially when you don’t really understand what your options are. This article will help you out by making things as simple as possible.

Two of the most popular types of retirement accounts are Roth IRAs and 401(k)s. These two retirement savings options have a lot in common, but once you learn a little more about them, you’ll see that the differences are as clear as day. 

We created this guide to help you understand how Roth IRAs and 401(k)s work, the differences between them, and how to decide which one is right for you.

What Is A 401(k)?

A 401(k) is a retirement savings plan that is offered by your employer (though there is a version for the self-employed, as we’ll see). The plan allows you to invest money into the account, usually by deducting a certain percentage or a specific dollar amount from each paycheck. Any money you contribute will be invested in various mutual funds. Many employers will also match the contributions you make up to a certain percentage of your salary, which allows your account to grow even faster.

What makes a 401(k) plan special is that you can contribute to the account without being taxed on your investments. Your 401(k) investments will be deducted from your gross pay before taxes are calculated, so any money that you put in your 401(k) is not taxed in any way.

If you are thinking this is all sounding too good to be true, you’re right. Of course, there is a catch. And that catch is the contribution limit. Unfortunately, you can’t invest unlimited tax-free money into your 401(k). In 2020, the annual contribution limit to a 401(k) is $19,500, not including any employer match. However, if you are over the age of 50, you can make an additional $6,500 in annual catch-up contributions, for a total annual limit of $26,000.

What Is An IRA?

Before we talk about Roth IRAs, we should probably at least cover the basics of what an IRA is. An Individual Retirement Account (IRA) is a type of retirement savings account that you open personally and is not provided by an employer. A traditional IRA may allow you to make pre-tax contributions, but there are required minimum distributions after age 72 and your withdrawals will be taxed as current income after age 59½.

IRAs are an excellent option for people who own their own businesses, or who work for employers who don’t offer 401(k)s. Even if you do have a 401(k), an IRA can be a useful retirement savings tool once you max out your 401(k) contributions.

What Is A Roth IRA?

Similar to a traditional IRA, a Roth IRA is an individual account that is not employer-sponsored. However, a Roth IRA only permits you to contribute post-tax money. 

This doesn’t mean that Roth accounts don’t have tax benefits. Any withdrawals from your account are tax-free after five years and age 59½. This can result in a substantial tax break for people who plan to be in a higher tax bracket when they start receiving retirement plan distributions.

Some disadvantages of a Roth IRA are that there are income limits on who can use a Roth account, and, like 401(k)s, there are also contribution limits to how much money you can invest. 

Married couples who file taxes jointly and have a combined modified adjusted gross income (MAGI) of at least $206,000 and single people with a MAGI of $139,000 cannot invest in a Roth IRA. 

People whose incomes qualify them to use a Roth IRA cannot contribute more than $6,000 per year, or $7,000 if they are over the age of 50.

What Is The Difference Between Roth IRA And 401(k)?

Let’s quickly review the main attributes of Roth IRAs and 401(k).

401(k)s:

  • Employer-sponsored accounts
  • Contribute pre-tax dollars
  • Contribution limit of $19,500 or $26,000 if you’re over 50
  • No income limits to qualify

Roth IRAs:

  • Individual Accounts
  • Contribute post-tax dollars
  • Contribution limit of $6,000 or $7,000 if you’re over 50
  • Income limits for who can use

The primary difference between IRA and 401(k) accounts is that IRAs are personally-owned individual retirement accounts, whereas 401(k)s are profit-sharing plans provided by employers. 

On top of that, when it comes to Roth IRAs and 401(k)s, the accounts offer different tax advantages. 401(k)s allow you to contribute pre-tax, which reduces your taxable income so that you owe a lower amount of taxes today. Roth IRAs, on the other hand, only allow you to contribute post-tax funds, but your withdrawals later in life are then tax-free.

While it’s always wise to seek the advice of an expert, one of the primary factors when deciding whether a Roth IRA or a 401(k) is right for you is whether you want to save on taxes now or later.

Other Types of 401(k)s and IRAs

As part of our quest to demystify retirement savings accounts, we wanted to go over a few other types of 401(k)s and IRAs that may be better suited for your personal situation. Let’s compare and explain some additional options that you use when saving for retirement.

Simple IRA

Savings Incentive Match Plan for Employees (SIMPLE) IRAs are essentially traditional IRAs that are set up by an employer or a self-employed person. To qualify to establish a SIMPLE IRA program, an employer must have 100 or fewer employees who were paid $5,000 or more in the last year.

 Here are some of the defining features of a SIMPLE IRA:

  • Contribute pre-tax dollars
  • Taxed on distributions down the road
  • Established by employers
  • Cannot use 401(k) or Roth IRA

To learn more, check out our article, Solo 401k Vs. SIMPLE IRA: Which is Better for You?

SIMPLE IRA Vs. 401(k)

SIMPLE IRAs and 401(k)s are both types of employer-sponsored retirement accounts. The main difference between the two is that SIMPLE IRAs are simpler and easier for small businesses, whereas 401(k)s are more administratively complex but offer more flexibility and investment opportunities.

Roth 401(k)s

A Roth 401(k) is essentially a fusion of a standard 401(k) and a Roth IRA. Roth 401(k)s are employer-provided investment savings plans that only allow after-tax contributions, allowing for tax-free withdrawals later in life.

Roth 401(k) Vs. Roth IRA

While both Roth 401(k)s and Roth IRAs allow for post-tax contributions with tax-free distributions, the fundamental difference is that Roth 401(k)s are employer-sponsored and Roth IRAs are personal accounts.

Solo 401(k)s

Solo 401(k)s are also referred to as any of the following:

  • One-participant 401(k)
  • Solo-K
  • Uni-K
  • One-participant-K

A Solo 401(k) is a traditional 401(k) for business owners who have no employees and their spouses. Besides this one distinguishing factor, Solo 401(k)s follow the same rules and requirements as an ordinary 401(k) plan.

SEP IRA

A simplified employee pension (SEP or SEP IRA) is a retirement plan that businesses of any size, including the self-employed, can create. The SEP plan allows the employer to contribute to traditional IRAs established for its employees. The employer can then receive a tax deduction for contributions made to the SEP IRA. See The SEP for IRA LLC Solution: Retirement Savings For Small Businesses & The Self-Employed for more.

Solo 401(k) Vs. SEP IRA

Solo 401(k)s and SEP IRAs are both alternative types of employer-sponsored retirement plans. However, Solo 401(k)s are only available to business owners who have no employees, whereas SEP IRAs may be established by both employers and the self-employed. 

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