Among the many questions I get about retirement, one of the most prevalent is: Should I use a 401(k) or a Roth individual retirement account? Can I do both?
People also ask what’s a Roth 401(k)? How do they find out about their company match? They have a 403(b), what’s that?
Let’s break down the different ways to save for retirement and which one (or two) ways might be the best for your situation.
What’s the difference between a 401(k) and a Roth IRA? A 401(k) is an employer sponsored retirement plan. You make contributions deducted from your paychecks before your company takes out taxes. (This is known as a “pre-tax” contribution.) A 403(b) is very similar to a 401(k) but it is for employees of nonprofits and government agencies.
You can have any type of IRA (Roth IRA, traditional IRA or rollover IRA) at any brokerage firm and it is not tied to your employer. When the word Roth is put ahead of IRA or 401(k) it means that you pay taxes on the contributions up front.
For example, you receive your paycheck and then you make a $200 contribution to your Roth IRA. You already paid taxes when you received your paycheck, therefore it is funded with after-tax dollars or “post-tax” contributions.
By contributing to a 401(k) today, you get a tax benefit this year and then your contributions grow tax-free. But when you withdraw the money in retirement, you have to pay taxes on your distributions. A Roth IRA works in the opposite way: You pay the taxes up front but then the money grows tax-free. When you withdraw the money in retirement, you don’t have to pay taxes.
Take advantage of free money. The best way to start saving for retirement is by taking advantage of your 401(k) company match. Some employers offer a company match and some don’t, but it’s worth calling up your human resources department or looking in your company benefits package to see what your employer offers.
Always contribute at least enough to your 401(k) to get your full company match. For example, if your company matches half of the first 6% percent, then you want to contribute at least 6% so you earn the 3% match. This is one of the few times in life where you can get free money – don’t pass it up. Employers don’t sponsor IRAs, so they won’t match those contributions.
It all comes down to taxes. Once you contributed enough to earn your full company match, then it’s time to look at your tax bracket. The higher your bracket, the bigger tax benefit you receive in your 401(k). So if you’re in the 35% bracket, then you probably want to contribute the maximum to your 401(k), which is $17,500 per person per year for 2013, regardless of income.
If you earn $200,000 and contribute $17,500, then you only pay taxes on $182,500. However, if you’re in a lower tax bracket, like 15% or 25%, then you might want to contribute to a Roth IRA, especially if you think you’ll be in a higher bracket in the future. Since you fund that account with after-tax dollars, you may be better off contributing to your Roth IRA since you won’t have to pay taxes when you withdraw the money from it in retirement.
If your company doesn’t offer an employer match on your 401(k), consider skipping it and heading straight for the Roth IRA. You can contribute a maximum of $5,500 per year to a Roth IRA for 2013.
Can anyone contribute to a Roth IRA? No. You have to have earned income. For example, if you are a full-time student and don’t have a job, then you can’t contribute to a Roth IRA. (Unless your spouse has earned income, in which case, you may qualify.)
Also, there are income limits. If you are single and you make more than $127,000, you don’t qualify to make Roth IRA contributions. If you are married and make more than $188,000, you and your spouse earn too much to qualify for Roth IRA contributions. This number is based on what’s called your modified adjusted gross income (MAGI), which you can find on your tax return. It adds back such items as IRA deductions and college outlays.
I’m Gen Y. Isn’t it always best to contribute to a Roth IRA? Not necessarily. Some people make the argument that tax brackets will be higher in the future, so if you’re young you should always contribute to a Roth IRA or Roth 401(k) because you will pay more in taxes later, even though we don’t really know how much exactly.
I think that having some tax-deferred money, in a 401(k) or IRA, and some money in a Roth is a good thing because it allows you to have different tax buckets in which to pull your money from in retirement. The higher your tax bracket, the more I encourage you to contribute to a 401(k). Whereas, if you’re in a lower tax bracket, contribute to a Roth IRA.
Don’t wait, just start. The biggest error I see Gen Y make is to wait to start saving for retirement. Some people won’t start a Roth IRA because it takes more effort to open the account and it’s easier for them to just sign up for their 401(k) at work. If that’s you, then do that. Sign up for your 401(k) today. If you’re already contributing, then increase your contributions by 1% today.
What are you waiting for? Small changes add up to big results over time. Just start.
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Sophia Bera, CFP, is a fee-only financial planner that caters investors in their 20s and 30s. She has been in the financial planning industry since 2007 and is the founder of Gen Y Planning in Minneapolis. She works with clients throughout the U.S. She has been quoted on various websites and publications including Forbes, Business Insider, AOL, Yahoo, Money Magazine, The Fiscal Times, Fox Business, and The Huffington Post Money Under 30 recently named her one of the “Top Financial Advisors for Millenials.”
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