If you have limited funds to invest for retirement, you may be wondering whether to fund your 401(k) plan or a Roth individual retirement account (IRA). Before deciding, make sure you understand the basics of each alternative.
In 2018, you can contribute up to $18,500 to a 401(k) plan. If you are age 50 or older and your plan permits, you can make an additional $6,000 catch-up contribution bringing your maximum 2018 contribution to $24,500 (up from $18,000, $6,000, and $24,000 respectively). Those contributions are deducted from your gross pay, so you don’t pay current income taxes on them (you still must pay Social Security and Medicare taxes). Earnings and capital gains grow tax deferred until withdrawn. When funds are withdrawn, you pay ordinary income tax rates on the contributions and earnings (a 10% penalty may also apply if withdrawals are made before age 59 1/2). Additionally, many employers match some portion of an employee’s contribution to 401(k) plans.
Roth IRA Contributions
While contributions to a Roth IRA are not tax deductible, earnings on qualified distributions are taken on a federal income tax-free basis. A qualified distribution is one made after age 59 1/2 and at least five years after contributions begin. The maximum contribution in 2018 is the lesser of $5,500 for individuals or $11,000 for married couples or joint earned income (unchanged from 2017). Additional catch-up contributions of $1,000 can be made by individuals age 50 and older. Eligibility to make contributions is phased out at adjusted gross income levels starting at $120,000 for single taxpayers and $189,000 for married taxpayers filing jointly (up from $118,000 and $186,000 respectively for 2017). Contributions can be made even if you contribute to a 401(k) plan.
Taking the contribution limits into consideration, here are some questions to answer:
What are your alternatives? If your employer matches contributions in your 401(k) plan, you should probably first contribute enough to take advantage of all matching contributions. The matching can substantially boost your retirement savings. For example, assume your employer matches 50 cents on every $1 you contribute and you’re in the 24% tax bracket. For every dollar you put in the plan, $1.50 is invested at a cost to you of 76 cents on an after-tax basis. After that, you can decide whether to continue contributing to your 401(k) plan or to a Roth IRA.
Will you need the funds before age 59 1/2? Funds from a 401(k) plan can only be withdrawn in certain limited circumstances and typically result in the payment of ordinary income taxes and a 10% federal income tax penalty for distributions before age 59 1/2. As an alternative, many plans have loan provisions, allowing you to take a loan equal to the lesser of half your account’s value or $50,000. With a Roth IRA, you may withdraw your contributions at any time with no tax consequences.
In addition, earnings may be withdrawn with no tax consequences after the five-year holding period due to death or disability, to pay up to $10,000 of qualified first-time home-buying expenses, or after age 59 1/2. Earnings can also be withdrawn to pay qualified higher-education expenses, paying normal income taxes but no federal income tax penalty. Non-qualified withdrawals of IRA earnings for other purposes are subject to ordinary income taxes and a 10% federal income tax penalty.
Are you satisfied with the investment options offered by your 401(k) plan? Contributions to a 401(k) plan must be invested in one of the options offered by the plan. While some plans offer numerous options, others offer only a limited selection. You can invest your Roth IRA contributions in a wide variety of investment alternatives.
Will you need the funds for retirement? Withdrawals must be made from a 401(k) plan by the later of age 70 1/2 or when you retire. With a Roth IRA, you aren’t required to make withdrawals during your lifetime.