An Overview of Roth IRA and 401(k) Retirement Plans
Each type of account has key features, distinguishing elements, and potential advantages. Let’s explore the fundamental rules and requirements for contributing to these accounts to give you a firm foundation for your retirement strategy.
What is a Roth IRA?
The Roth IRA is a unique type of Individual Retirement Account that permits you to contribute after-tax dollars. These accounts are not tied to any employer. The key advantage is that the Roth IRA allows for tax-free withdrawals, provided certain conditions are met.
One of the standout benefits of the Roth IRA is the absence of Required Minimum Distributions (RMDs). This gives you the luxury of control as it relates to the timing and distribution of your retirement funds. If you’re financially secure, it allows you to keep your funds invested and pass them down to your beneficiaries, potentially tax-free.
Each year, the IRS outlines the contribution limits for various retirement account types. In 2023, the maximum annual contribution to a Roth IRA is $6,500, plus an additional $1,000 catch-up contribution if you’re 50 or older.
The tax advantages of a Roth IRA are valuable. But the account does come with some stipulations about income limits.
To be eligible to contribute directly to a Roth IRA, your Modified Adjusted Gross Income (MAGI) for 2023, when filing as a single person, would need to be less than $153,000 ($228,000 if MFJ).
What is a 401(k)?
A traditional 401(k) is an employer-sponsored retirement plan that allows you to make pre-tax contributions (before tax is deducted). This account is available to you if your employer offers it as a retirement benefit, or if you work for yourself and create your own 401(k) plan.
Pre-tax contributions lower your taxable income for that year, providing immediate tax savings. Because of these tax-deferred contributions, you’ll have to pay income tax on withdrawals in retirement, unlike Roth IRA or Roth 401(k) retirement accounts (as of 2024, for Roth 401(k)s).
A key feature of many 401(k) plans is the employer match, where your employer contributes a certain amount to your 401(k) account, typically matching your contributions up to a certain percentage. Some savers view this as “free money”.
The primary benefits of a 401(k) plan include the potential for tax-deferred growth and significantly higher contribution limits as compared to a Roth IRA.
In 2023, individuals can contribute up to $22,500 to their traditional 401(k), with a $7,500 catch-up contribution for those 50 and older. Including your employer contribution, your total employee and employer contributions cannot exceed $66,000 (or $73,500, if you add the catch-up amount).
Roth IRA Income Limits and Eligibility
Certain income limits and eligibility requirements govern Roth IRA contributions:
- Your Modified Adjusted Gross Income (MAGI) is pivotal in determining your eligibility. For 2023, the maximum permitted MAGI to make direct Roth IRA contributions is $153,000 when filing taxes as a single person.
The Internal Revenue Service (IRS) sets specific phaseout ranges for different filing statuses, which affect the amount you can directly contribute to a Roth IRA each year.
For 2023, those ranges are:
- Single: $138,000-$153,000
- Married filing jointly: $218,000-$228,000
- Married filing separately: $0-$10,000
If your MAGI falls in between the two numbers, you can make a partial direct contribution.
401(k) Contribution Limits and Rules
Contribution limits and rules govern 401(k) plans. These include annual contribution limits, as well as catch-up contributions for those who are 50 years old and above. Employer matching contributions also factor into the equation, influencing the total amount you can contribute to a 401(k)in a given year.
It’s important to note that these limits apply to both traditional pre-tax contributions and after-tax Roth 401(k) contributions, should your employer offer that option.
- In 2023, individuals can contribute up to $22,500 to their traditional 401(k), with a $7,500 catch-up contribution for those 50 and older.
- Including your employer contribution, your total contributions cannot exceed $66,000 (or $73,500 if you add the catch-up amount).
These contribution limit thresholds are in place since your pre-tax contribution can help lower your tax bill for that tax year, and potentially push you into a lower tax bracket altogether.
Benefits of Having Both a Roth IRA and a 401(k)
Holding a Roth IRA and a 401(k) in your retirement portfolio can unlock several potential benefits. In this section, we’ll explore how these two accounts can complement each other and enhance your retirement strategy.
Tax Diversification
The tax benefits are among the most compelling reasons to have a Roth IRA and a 401(k). A Roth IRA uses after-tax dollars for contributions, whereas a traditional 401(k) employs pre-tax contributions.
Consequently, your investments can grow tax-free in a Roth IRA, whereas they grow tax-deferred in a 401(k). This allows you to manage your tax exposure at different stages— contributions, growth, and withdrawals—potentially minimizing your overall tax liability during retirement.
You’ll benefit from tax-deductible contributions toward your 401(k), which lower your income tax rates for the years in which you make contributions. With your Roth IRA, you’ll benefit from not having to pay income tax on withdrawals down the line.
Higher Total Contribution Limits
Having both a Roth IRA and a 401(k) enables you to maximize higher combined contribution limits. IRA contribution limits are lower than those for a traditional 401(k), so having both accounts can increase your overall annual contribution limits. This means you can stash away more money for your retirement, potentially securing a more comfortable lifestyle in your golden years.
Investment Options
With a Roth IRA and a 401(k), you inherently broaden the spectrum of investment options available. This diversification can be a powerful tool in managing investment risk more effectively, as it lets you distribute your retirement savings across different investment vehicles, such as stocks, bonds, and mutual funds.
Solidify Your Retirement Plan With a Roth IRA and a 401(k)
Maintaining a Roth IRA account and a 401(k) can offer many benefits, including tax advantages, expanded contribution limits, and a more comprehensive range of investment options.
Partnering with a trusted financial advisor can be invaluable in making informed personal finance decisions about your retirement savings strategy.
Capitalize is here to help you navigate the complexities of finding and consolidating your old 401(k) retirement accounts.
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