When people think of retirement, their first thought, besides sitting on a beach in Fiji, is typically 401(k) and Individual Retirement Accounts (IRA & Roth IRA). You’ve probably heard these terms thrown around during conversations. But do you know the difference? In The U.S., around 63% of people don’t fully understand 401(k)s, and 66% don’t fully understand IRAs and Roth IRAs. That lack of understanding undoubtedly prevents Americans from investing in 401(k)s or IRAs. Essentially, 401(k)s and Roth IRAs are retirement investment accounts. The money that is in these accounts is invested into various parts of the market, such as stocks, bonds, mutual funds, index funds and ETFs (exchange-traded funds). So, what’s the difference between these two?
Offerings and taxation
The two main differences between these accounts are how they’re offered and the way they’re taxed. Employers offer 401(k)s and are typically managed by a separate financial firm such as Vanguard, Fidelity, Principal or Schwab. Meanwhile, IRAs and Roth IRAs are opened by individuals, typically at a bank or investment firm. As for taxes, you fund Roth IRAs with after-tax income. This means when it comes time to withdraw your savings during retirement, that income isn’t taxed. A 401(k) is funded with pre-tax income, meaning that when you withdraw your funds during retirement, it is taxed.
Contribution limits and withdrawal windows
Two other key differences are contribution limits and time of withdrawal. You can contribute more money to a 401(k) than a Roth IRA. A Roth IRA has a contribution limit of $6,000 if you’re under age 50 and $7,000 if you’re age 50 or older. A 401(k) has a contribution limit of $19,500 if you’re under age 50 and $26,000 if you’re age 50 or older. For withdrawals, Roth IRAs allow you to withdraw your initial contributions at any time with no tax or penalty. However, early withdrawals on earnings are subject to income taxes and a 10% penalty depending on age (59½ years) and how long you had the Roth IRA account (five years). With a 401(k), there is a required minimum distribution, which begins at age 70½.
Now that you know the differences between 401(k)s and Roth IRAs, how do you know which one you need? We made you a pro and con list.