Published By: Tarrence Sun | 06/08/2024

What Is a 401(k)?

A 401(k) is a retirement savings plan sponsored by your employer. It allows you to contribute a portion of your pre-tax income directly from your paycheck. Here are the key points about 401(k)s:

Tax Benefits: When you contribute to a traditional 401(k), the money is deducted from your paycheck before taxes are applied. This means you get an immediate tax benefit because your taxable income is reduced. However, keep in mind that you’ll pay taxes on the withdrawals during retirement.

Employer Match: Many employers offer a matching contribution to your 401(k). For example, if you contribute 5% of your salary, your employer might match that with an additional 5%. This is essentially free money, so take advantage of it if your employer offers it.

Contribution Limits: The IRS sets annual contribution limits for 401(k)s. As of 2024, the maximum contribution is $20,500 for individuals under 50 years old. If you’re 50 or older, you can make an additional “catch-up” contribution of $6,500, bringing the total to $27,000.

Investment Options: Your employer selects the investment options available within the 401(k) plan. These options can include mutual funds, index funds, and sometimes company stock.

Required Minimum Distributions (RMDs): Once you reach age 72 (or 70½ if you were born before July 1, 1949), you must start taking RMDs from your traditional 401(k). These withdrawals are subject to income tax.

What Is a Roth IRA?

A Roth IRA is an individual retirement account that you can open yourself. Here’s what you need to know about Roth IRAs:

Tax-Free Growth: Unlike a traditional 401(k), you contribute to a Roth IRA with after-tax dollars. This means that the money you invest has already been taxed. However, the growth inside the Roth IRA is tax-free, and you won’t owe any taxes when you withdraw the money in retirement.

No RMDs: Roth IRAs do not have required minimum distributions (RMDs) during your lifetime. You can leave the money in the account to continue growing tax-free.

Income Limits: Roth IRAs have income limits. As of 2023, individual taxpayers with an adjusted gross income (AGI) over $161,000 (or $240,000 for married couples filing jointly) are not eligible for Roth IRA contributions.

Investment Flexibility: You have more control over your investments in a Roth IRA. You can choose from a wide range of investment options, including individual stocks, bonds, mutual funds, and exchange-traded funds (ETFs).

Why Invest in a 401(k)?

Employer Match: If your employer offers a matching contribution, take advantage of it. It’s essentially free money.

Tax Benefits: Contributing to a traditional 401(k) reduces your taxable income today, which can lower your current tax bill.

Automatic Contributions: 401(k)s allow automatic contributions directly from your paycheck, making saving effortless.

Cons of 401(k):

• Limited Investment Choices: 401(k) plans typically offer a curated selection of investment options, limiting your control over individual investment choices.
• Early Withdrawal Penalties: Withdrawing funds before the age of 59½ may result in penalties and taxes, discouraging early access to savings.

Why Invest in a Roth IRA?

Tax-Free Growth: Roth IRAs offer tax-free growth, meaning you won’t pay taxes on the money you withdraw during retirement.

No RMDs: No required minimum distributions during your lifetime, allowing your investments to grow for as long as you want.

Investment Flexibility: Choose from a wide range of investment options tailored to your preferences.

Cons of Roth IRA:

• One significant disadvantage of Roth IRAs is the annual contribution limit imposed by the IRS. The contribution limit for individuals under the age of 50 is $6,000 per year, and for those 50 and older, there is an extra $1,000 room added to the limit.
• No Immediate Tax Deduction: Unlike the 401(k), contributions are made after tax, so there’s no immediate reduction in taxable income.
• Income Restrictions: High-income earners may be restricted from contributing directly to a Roth IRA.

Conclusion

Both 401(k)s and Roth IRAs have their advantages. Consider contributing to your 401(k) up to the employer match and then opening a Roth IRA. Aim to invest 15% of your gross income for a secure retirement. Seek professional advice and invest wisely in growth stock mutual funds.