Roth IRA vs. 401(k): Which is better for retirement savers?

Understanding 401(k) plans

A 401(k) is a retirement savings vehicle that's offered by employers. Soon, the federal government plans a big change to enroll people automatically in their companies’ 401(k) plans, unless you opt out.

With a 401(k), you decide how much of your pay you want to contribute, typically a percentage of your salary.

Your employer will transfer the money into the account before any taxes are withheld, and your savings are invested — most often in mutual funds made up of stocks and bonds.

Contributions to a 401(k) throughout the year lower your taxable income, and some employers even match what you put in — up to a point. Millions of people miss out on the money employers contribute to 401(k)s, and the automatic enrollment plan, a bipartisan effort working its way through Congress, is meant to remedy that problem.

There are limits on how much you can contribute each year, which the government raises by $500 to $1,000 every one to three years. Currently, you can contribute over $20,000 per year, and even more if you’re over age 50.

A 401(k) is a pretty painless way of saving for retirement that makes it difficult for you to spend the money you've set aside.

Take the money out early and you'll have to pay taxes, plus you may face a 10% penalty. "Early" means before age 59 1/2. Could they have made it more random? After you've reached that age, the withdrawals are taxed as regular income.

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The change coming to 401(k)s

There is broad support in Congress for the plan to require employers to automatically set up 401(k) accounts for eligible employees at a savings rate of 3% of their annual income. Each year, their savings rate would increase by 1% per year until it reaches 10%.

You can choose not to contribute or change the amount of contributions.

In March, the House almost unanimously passed the legislation, called Setting Every Community Up for Retirement Enhancement (SECURE) Act 2.0.

If the Senate and President Joe Biden agree to the proposal as expected, the SECURE 2.0 bill also would:

• Increase the after-tax catch-up contribution limit to $10,000 for workers ages 62 to 64.
• Allow employers to match the student loan payments you make with a deposit into your 401(k).
• Enable part-time workers to contribute to 401(k) plans.
• Raise the age when people must take required minimum distributions, or RMDs, from 72 to 75.

How a Roth IRA is different

A Roth IRA (individual retirement account) is similar to a 401(k), though with the taxes flipped.

You put part of your income into the account after taxes have been taken out, and you pay no tax when you withdraw the money in retirement — not even on your investment earnings.

This account can contain a variety of investments including mutual funds, bonds, stocks, securities and even certificates of deposit (CDs), just to name a few. As with a 401(k), a savings cap is applied on an annual basis.

If you really want your Roth IRA to feel like a 401(k), you can set up automatic contributions from your paycheck through direct deposit.

You're eligible to save in a Roth IRA only if your income (either individual, or joint if you're married) is below a certain threshold. The limits change each year and can be found on the IRS website.

Similar to a 401(k), you may face a stiff 10% penalty if you make early withdrawals from the account's earnings (though not your contributions). Again, "early" means before age 59 1/2.

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A possible Roth IRA change to keep an eye on

In 2022, high-income earners who make over $144,000 as single taxpayers (or $214,000 filing jointly) are not eligible to contribute to a Roth IRA account — at least not directly.

Wealthy people have long used a loophole called the backdoor Roth IRA, contributing unlimited after-tax dollars into traditional IRAs or 401(k)s, then converting to a Roth IRA for tax-free withdrawals in retirement.

Late last year, it looked like Congress might eliminate the Roth conversion loophole for single filers who earn over $400,000 (or $450,000 for joint filers). But the proposal was part of Biden’s centerpiece Build Back Better spending plan, which lawmakers squashed.

Roth IRA vs. 401(k): Which is best for you?

When deciding between a Roth IRA and a 401(k), there are many factors at play, including:

• Your income.
• Your 401(k) investment options.
• Your 401(k) employer match program.
• Your expected retirement income tax bracket.

If your income exceeds Roth IRA contribution limits, the decision is easy — invest in a 401(k). And if you have more to invest, you could consider a backdoor Roth IRA conversion.

If your income fits within the range allowed for Roth IRA investments, you could start by reviewing your company’s 401(k) investment options and matching program. If you don’t like the investment funds offered by the 401(k), perhaps because of high fees or low performance, consider contributing enough to your 401(k) to receive the maximum matching benefit, then investigate a Roth IRA with strong investment options for a portion of your retirement savings.

Lastly, don’t forget tax implications. Roth IRA contributions are taxed now, while 401(k) funds are taxed when you retire. If you expect a lower tax bracket in retirement, a 401(k) might make more sense. But if you currently fall in a low tax bracket and expect it to be higher in retirement, a Roth IRA could be the right move.

Whatever you do, don’t let yourself get stuck in analysis paralysis. If you’re having trouble deciding which is right for you or understanding the Roth IRA conversion rules, you can always meet with a retirement financial adviser for help.