Empty beach chairs on sand facing the ocean.

Retirement Options: 401(k), Roth 401(k) or Roth IRA?

June 26, 2024

With the rising cost of living and increasing longevity, it's important to start planning for retirement as early as possible. Fortunately, there are various retirement choices available to help you save and invest for your future.

401(k)s Offer Tax Breaks and Matching Contributions

One of the most common retirement options is the 401(k), offered by most employers. The 401(k) plan lets you contribute a portion of your pre-tax income to a retirement savings account. A great perk: Employers usually match contributions, typically from 2% to 8%.

Your savings grow tax-deferred, meaning you won’t pay taxes on the earnings until the money is withdrawn in retirement. However, once you turn 72, you’ll be required to take minimum distributions. Until then, money in your 401(k) account grows tax-free. At that time, withdrawals are taxed as ordinary income.

There are some disadvantages to contributing to a 401(k) plan, too. You may have to pay fees to invest in the plan and could be limited in your investment choices. Also, you won’t be able to withdraw your money without penalties before you reach age 59½.

Roth 401(k)s Use After-Tax Dollars

Another popular retirement option is the Roth 401(k). It’s like a traditional 401(k) with one big exception: Employees use after-tax — rather than pre-tax — income to make contributions. This means you won’t receive a tax deduction for your contributions, but your withdrawals in retirement are tax-free. This tax-free growth potential can be beneficial for individuals expecting to be in a higher tax bracket during retirement.

But Roth 401(k)s may not work for some people, because they’re subject to income limits. Individuals should consult with a financial advisor or tax professional to determine their eligibility for Roth 401(k) contributions based on their income and other factors.

Roth IRAs Have Income Limits

Roth IRAs are individual retirement accounts that are funded with after-tax dollars, but qualified withdrawals are completely tax-free. This means that you don't get a tax break on your contributions, but you won't have to pay taxes on your withdrawals in retirement. Roth IRAs have the same contribution limits as traditional IRAs.

There are some important things to keep in mind when considering a Roth IRA. First, Roth IRAs are subject to income limits. If your income is too high, you may not be able to contribute to a Roth IRA. Learn more about the income limits.

Roth IRAs also have a five-year holding period. This means that you must wait five years from the time you contribute to a Roth IRA before you can withdraw the money without penalty. However, there are some exceptions to the five-year holding period, such as if you withdraw the money for qualified education expenses or if you become disabled.

Trying to Choose the Right Option

When selecting the most suitable retirement option, consider these factors:

  •  Your age and the time remaining until your retirement.
  • Your current income tax bracket.
  • Your investment objectives and risk tolerance.
  • The availability of employer matching contributions and the contribution limits associated with each option.

Considering your age and investing time horizon until retirement is essential as it influences the potential growth and accumulation of your retirement savings. If you are younger and have a longer time before retirement, you may have a higher risk tolerance and can consider options with greater growth potential, such as stocks. Conversely, if you are closer to retirement, you may prioritize capital preservation and opt for more conservative investments like bonds.

Traditional 401(k) and traditional IRA contributions offer tax deductions upfront, potentially reducing your current tax liability. However, the withdrawals from these accounts during retirement are taxed as ordinary income. Roth 401(k) and Roth IRA contributions are made with after-tax dollars, but qualified withdrawals are tax-free. If you expect to be in a higher tax bracket during retirement, Roth options may be more beneficial.

Understanding your investment goals and risk tolerance is crucial when selecting a retirement option. If your primary goal is capital preservation and you have a low risk tolerance, you may prefer safer investments such as bonds or share certificates. However, if you are seeking long-term growth and can handle market fluctuations, you may consider including stocks or stock mutual funds in your portfolio.

Employer matching contributions can significantly impact your retirement savings. If your employer offers matching contributions for your retirement plan contributions, take advantage of this benefit. Employer matching contributions essentially represent free money that can boost your retirement savings.

Lastly, it is important to consider the contribution limits associated with each retirement option. These limits may affect how much you can contribute and accumulate in your retirement accounts.

This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.