What’s the Difference Between a 401k and Roth IRA?

Convinced we need to save for retirement, we seek understanding of the many retirement funds available to us. The biggest question out there involves the difference between a 401k and Roth IRA. I’ll answer that question in the simplest way.

It all comes down to taxes.

A 401k contribution is made from your gross income before taxes are taken out. Since you don’t pay taxes on a 401k contribution when it’s made, you pay taxes when it is withdrawn.

Conversely, a Roth IRA contribution is made after taxes are taken out. Since taxes have already been paid, you are not taxed when funds are withdrawn.

There are other differences, but this is the largest factor in deciding which is the best for your retirement plan.

Invest in Both 401(k) and Roth IRA

One of the reasons I love Roth IRAs is that I actually know how much money I have saved for retirement. Because this amount is already taxed, whatever I have there is the actual amount I will withdraw. Unfortunately with my 401k, I do not know exactly how much of my savings is actually mine to keep. And because it is taxed at my earning rate when I begin withdrawing (decades from now), I don’t know what the tax rate will be.

There are complicated exercises to minimize 401k taxes when the time comes. But for today, while I’m decades away from withdrawing from my 401k, I’d rather have peace of mind that I have saved enough for retirement. Hence a Roth IRA is my preferred retirement fund, and the reason why I advocate investing in one in addition to a 401k.

Invest at least the employer match to your 401k and contribute the maximum to your Roth IRA. Taking this approach will yield a healthy retirement fund if you begin contributing before your 40s. And as always, the earlier you start investing, the better off you will be.

Recommended Retirement Fund Contributions

  1. Contribute the employer match percentage to your 401(k)
  2. Contribute the maximum to your Roth IRA
    1. Maximum Roth IRA contribution for 2020 is $6,000
    2. For full contribution limits, check out NerdWallet’s Roth IRA contribution limits
  3. Contribute any additional retirement savings to your 401(k)
    1. Maximum 401(k) contribution for 2020 is $19,500
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