401k vs Roth IRA

Asset Management Tutorial

Differences between 401k and Roth IRA

People earn, spend and save. The earn and save components are the two factors which decide the future economic status of people. So generally during their young age, people tend to earn and save more so that they can use the corpus at some later point in time or during their retirement period. There are many retirement plans that can help people in achieving their long-term or retirement financial goals or commitments.

In this article, we are going to discuss two such financial plans which aim at helping people in saving money for retirement goals. Both 401k and Roth IRA are retirement plans with some technical differences between them.

What is a 401k?

401(k) is a financial retirement plan which is sponsored by employers which enable their employees to make contributions towards their retirement fund. The employers may choose to make a matching contribution on behalf of their employees. The employer may choose to add profit sharing feature as well to the plan. One thing to note in 401(k) plan is that the earnings accrue on a tax-deferred basis.

What is Roth IRA?

IRA refers to Individual Retirement Account. Roth IRA is a special type of retirement account that can be funded by the people with their post-tax income. There is a very lucrative type of retirement savings plan as all the future withdrawals are tax-free. Unlike traditional IRA, there is no up-front deduction of tax to the contributions made to Roth IRA.

401k vs Roth IRA Infographics

Here we provide you with the top 4 differences between a 401k vs Roth IRA –

401k vs Roth IRA – Key Differences

The key difference between 401k and Roth IRA are as follows –

Both 401k and Roth IRA aim at enabling the investor to amass a corpus sufficient enough to meet the long-term financial commitments which become difficult because as people grow old their capacity to earn comes to a standstill and many aspects like health come into play. Though A 401k and Roth IRA the retirement instruments have similar goals they differ in nuances that affect the way the corpus is achieved and distributions are made to the investors. Both of them mainly differ in tax treatment, contributions, investment options, distributions etc. The contribution to 401k and Roth IRA plans or accounts is rated from earned income and not from investment or rental income.
In a 401(k) plan, the employees set aside a portion of their monthly income to be contributed into the 401(k) plan for future purpose. These salary-deferral contributions happen before deduction of income tax from the monthly salary. The employer can choose to make its part of contribution in a number of ways, one of which is that employer matches the contribution made by the employee subjected to a certain limit. Since these contributions are deducted before paying income tax, it reduces the taxable salary and hence provides a tax shield for now. But when the investor reaches the retirement age and starts making withdrawals from the amassed corpus the tax is applied as per the income tax bracket in which the investor falls at that time (which is usually lower).
Roth IRA, a special variation of plain vanilla IRA, is set up between an investment firm and an individual. So, the individual’s employer is not involved in this setup. Also, the investment options are not restricted as per the plan provider and the investors have greater freedom than those of 401(k) plans. One of the striking features is that it is funded by after-tax money and avoiding any taxes on the withdrawals.

Head to Head Differences Between 401k vs Roth IRA

Let’s now look at the head to head difference between 401k vs Roth IRA

Basis – 401K vs Roth IRA	401(k)	Roth IRA
Definition	A retirement plan, sponsored by employers, allowing employees to make salary deferral contributions.	A special retirement account allowing people to save post-tax income for future financial commitments.
Contribution	Contributions made form salary deferrals.	Contributions made are from post-tax income.
Distribution	Distributions are taxable as per the tax slab of the person at the time of withdrawal.	Distributions are not taxable and hence allows the entire corpus to be available at the disposal of the investor.
Usage	It is beneficial for those who want to minimize their current tax payments and hence deferring the tax during their retirement when they will fall in lower tax brackets due to lesser income during retirement as compare to present income.	It is beneficial for those who want to minimize tax payments during retirement. Also, it also useful as an instrument for those who want to leave tax-free assets for their heirs.

Conclusion

401(k) plan’s main feature comes to surface especially when an employer matches the contribution of the employee by contributing additional money to the employee’s 401(k) account which is normally based on a certain percentage of the employee’s contribution. Some key features of 401(k) plan includes that the contributions lower the taxable income in the year in which they were made, the fund is less expensive as compared to other identical funds etc. There is some downside to this plan as well as limited control over investment selection, minimum distribution required, distributions being taxed at normal income tax rate etc.

Roth IRA proves to be more relevant for individuals who believe that they will fall in a higher than current income tax bracket when they retire. There are two primary benefits of Roth IRA. First, not only the withdrawals of contribution but also that of the returns earned over the years are tax-free. Second, there are no mandatory minimum distributions during the lifetime for Roth IRA, unlike traditional IRA. This helps in keeping and allowing the corpus to grow for heirs and that too tax-free.

Having seen 401k vs Roth IRA plans in detail, one could come to the conclusion that both provide excellent instruments to save for future and save on tax at the same time. Now one has to think about the timing of the tax benefit. If an individual thinks that his/her current tax bracket is very high then 401(k) plan makes more sense as it lowers the taxable income and saves for the future at the same time. Whereas if the individual thinks that the ultimate goal of the savings is to have a tax-free corpus during retirement or to leave tax-free assets for the heirs then Roth IRA is the way to go.