Roth IRA vs. 401(k)

This is Part 1 of my Investing for Beginners Series. If you have any retirement/investment questions, please ask below or e-mail me so that I can make a future post. Or e-mail me to guest post on investing. I always love hearing about what others have to say.

A common question that I am asked is regarding the differences of Roth IRAs and 401(k)s. However, I don’t know everything about them and all of the differences. I mainly have a Simplified Employee Pension (SEP) plan but I will go in depth on all three in order to give you a better idea.

I do have a Roth IRA account but I do not contribute enough (also, my work does not offer 401(k)s, so I don’t participate in that). Yes, I know, I’m a bad personal finance blogger since I am not investing in myself nearly enough, but instead I am mainly paying off debt.

SEP Plans
SEP plans are where employers set aside money in retirement accounts for themselves and their employees. This is mainly done by smaller companies. Everyone in the company gets the same percentage in their SEP plan, and only the company puts money in.

I don’t put in a dime (and I don’t have the option, as with SEP plans, only the employer can put money in) and this is the main difference between the others.  Also, you pay tax when you take it out. You can take money out for certain events (such as school) without paying a penalty (only taxes will have to be paid).

A SEP allows for a contribution from the employer of up to 25% of the employee’s pay and benefits. Last year I received a contribution of around 16-17% of my yearly salary (salary plus health benefits cost). And my company guarantees at least 5% of your quarterly pay will be put into the account each quarter.

SEP plans are very nice to have (at least for me). It requires no contribution from me and is not allowed. I am very grateful that my company offers this. However, unless your company offers this, you cannot participate, so I will go into more detail on Roth IRA and 401(k)s instead!

With Roth IRAs and 401(k)s, it really depends on you and what you plan on doing. There are pluses and minuses for both (as with most things in life!).  The Roth IRA and the 401(k) are not tax free, as taxes are due at different times (this is the main difference).

Roth IRA

Roth IRAs are offered by company’s such as Fidelity (anyone can sign up), which is another difference from 401(k)s as described below. With a Roth IRA, the tax is paid immediately once you get it.  Then the money is put into your Roth account.  This money is then compounded over time and is tax-free. This means whenever you do decide to withdraw funds from this account, it is not taxed. Being taxed immediately with a Roth IRA can be a good idea if you think tax rates will only go up and/or if you think you will only continually make more higher (and thus taxed at a higher rate). Read More.

In 2012, you can contribute up to $5,000 (after-tax income), or $6,000 if you are 50 or older. Similar to the SEP plan, if a person withdraws money from their Roth IRA account before they are 59½, they will get a penalty.  With a SEP plan this penalty is 10%.  However, similar to the SEP plan again, a person can avoid the penalty in certain instances, such as when buying a house or paying for school.

401(k)
These are offered directly by employers. Many employers provide a “match” for what you contribute (I will be talking about company matches in a post coming soon by the way). If you’re company matches, sign up! This is FREE money.

Now with the 401(k), it is taxed AFTER you withdraw the money.  You put money into your 401(k) account pretax, and then when you withdraw, you pay taxes.

Getting taxed afterwards isn’t always a bad idea though. If you make a lot of money now and suspect that once you retire you will be making less, then it can be a good idea. This is because your tax rate will most likely be lower since you’ll be making less. In 2012, the 401(k) contribution limit is $17,000. People age 50 and over can contribute $22,500 (an extra $5,500).

Find more about Roth IRAs here, and how to start one here.
Find more about 401(k)s here.

Which do you have?
Why did you choose it?
Any questions?

Comments

  1. LifeAnt says

    So, as far as 401k vs. Roth 401k, the way the math works as far as which one leads to a greater result, the only difference is whether taxes are higher Now or Later. If Tax rates are the same there is absolutely no difference. So, what the auther neglects to mention, is that a Roth is a way to “invest” in different Tax years similiar to other investments.

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