The 401(k) is the retirement savings options that is probably most well known because many employers use one. A 401(k) is an employer sponsored plan that pulls money from your paycheck and deposits it into your retirement account before income taxes are taken out. Some employers will match your contributions, up to a certain percentage. When it comes time to take money out of the 401(k), this money is then subject to income tax, since you did not pay income tax at the time of contribution.
The positive side of paying income taxes later is that you may very well be in a lower tax bracket come retirement age than you are in your prime earning years. This could mean tax savings for you in the long run. There is also no upper income limit that could inhibit you from contributing to a 401(k). There are, however, limits on how much an individual can contribute per year. In 2016, an individual can contribute at most $18,000 in a single year, and an employee and employer together can contribute at most $52,000.
Here are the major benefits of having a 401(k):
- You could end up paying less in taxes overall.
- Your employer might match your contributions—something you should always take advantage of when possible because it’s essentially free money.
- Usually money is taken directly out of your paycheck, before it even gets to you, making it much easier to part with this money for the time being.
One potential drawback with 401(k)s is that you have less control over your investment options, as it’s really up to which management and investment options are tied to the company offering your 401(k) plan.
A Roth IRA is an individual retirement account that you set up on your own with an investment firm. The major difference between a 401(k) and a Roth IRA in terms of taxes is that you have already paid income taxes on any contributions you make to a Roth IRA. This means that when it comes time to withdraw funds from your Roth IRA, you can withdraw everything tax-free at that point. There is an advantage to paying taxes prior to contributing to your IRA if you think you’ll be making more money toward the end of your career; so a Roth IRA could also mean tax savings for you in the long run if your income peaks toward the end of your career.
There are, however, limits on who can contribute to a Roth IRA. An individual can contribute at most $5,500 per year to a Roth IRA, and if you make more than $116,000 per year individually, you may not be able to contribute to a Roth IRA at all.
Here are the major benefits of having a Roth IRA:
- You can withdraw retirement funds tax-free.
- After the age of 59, you can withdraw funds from your IRA without penalty.
- You have more control over how your money is managed and invested, since you are choosing the investment firm that presides over your Roth IRA account.