A Roth IRA is a far different savings account from a traditional 401(k).
They differ in tax treatment, investment options, and employer contributions. Knowing where and why they differ can help you understand when to switch over from a Roth IRA to a traditional 401(k).
Traditional 401(k) plan
The 401(k) plan, named after section 401(k) of the Internal Revenue Code, is an employer-sponsored retirement plan. Employees can designate a percentage of each paycheck, before taxes are deducted, to be diverted into their 401(k) account. Money withdrawn from a 401(k) is subject to income taxes as if it were income earned; however, investments in a 401(k) are exempt from capital gains and dividend tax.
A Roth IRA is another type of retirement account, but it’s set up directly between an individual and an investment firm — no employers invited.
The money invested comes from your after-tax income, but any investment gains are shielded from capital gains tax as well as dividend tax throughout the life of the investment. On top of that, the funds in a Roth IRA can be withdrawn free of income tax. In 2017, the maximum annual contribution is $5,500 for those under the age of 50, while those ages 50 and up can contribute $6,500 per year.
A Roth IRA grants an investor access to a huge variety of investments, whereas a 401(k) limits savers to a handful of funds offered by that particular plan. Like a 401(k), it also shelters investments in the account from capital gains and dividend tax. Both of these attributes make the Roth IRA extremely attractive for many people. However, there are nonetheless some reasons why you should consider rolling a Roth IRA over a traditional 401(k) retirement account.
You would rather not pick your own investments
A Roth IRA gives an investor greater control over their portfolio, allowing them to choose from thousands of stocks, bonds, mutual funds, ETFs, certificates of deposit, and more. But choice is not always a good thing. If you’re an inexperienced investor, or an overly hands-on investor who can’t resist the temptation to trade incessantly, then a 401(k) could save you from yourself.
401(k)s have a limited menu of investment options, and each should, theoretically, be suitable for a retirement saver. Most plans offer target date funds, index funds, and diversified mutual funds. Any of these choices would take a lot of the work out of investing for retirement.
You’ll have a lower income in retirement
If you do the math and realize that after you retire, you will be in a lower tax bracket, then it would be smarter to invest in a traditional 401(k). A Roth IRA is funded with after-tax income. The advantage is that your future withdrawals are not taxed, whereas the withdrawals made from a 401(k) are taxed.
Suppose you live in the state of New York and made $100,000 this year. Your effective tax rate is about 30%, and your marginal tax rate is about 40%. If you were to make $100 more, $40 of that would go to the tax man. Now let’s imagine that when you retire you drop down into a lower tax bracket, and your effective tax rate is about 25%.
If you use a 401(k), the money you contribute each year does not count as part of your taxable income (thus you don’t pay any taxes on it), and when you retire, you’ll pay a lower tax rate upon withdrawal (25% vs 30%).
You make too much money
If you exceed any of these income levels you can switch over to a 401(k). Additionally, if you want to set aside more than the $5,500 maximum contribution, then you can allocate that overflow to a 401(k).
Generous employer match
As there are no employers involved in a Roth IRA, there is naturally no opportunity for an employer match.
401(k) plans are at their most beneficial when an employer offers to match an employee’s contribution, sometimes between 50% and 100%. With a 50% match, if an employee contributes 8% of their salary to a 401(k) then their employer will contribute a further 4%. The match does not count toward your contribution limits (though your employer is also subject to contributions; you and your employer combined cannot contribute more than $54,000 this year).
If your employer offers a generous 401(k) matching program, then it would be prudent to take advantage. After all, what other investment can guarantee a 50% to 100% return?
Knowing the ins and outs of both types of savings vehicles can help you make the right choices for your retirement.
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