Do Not Run Out of Money! What You Need to Know About Funding your Retirement
An explanation of 401(K), Roth IRA, and Roth 401(K)
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Buckle up for this one because we are getting into the weeds.
Most people are familiar with 401(K) accounts, but what about Roth IRA and Roth 401(K) accounts? In this post I am going to break down the differences between all three.1
How Each Are Created and Who Contributes
Employer-sponsored retirement program, meaning created by your employer.
Workers set a dollar or percentage amount out of each paycheck to contribute to this account.
Many employers provide 401(K) matching, meaning employers will contribute money to your 401(K) up to a certain percentage.2
Setup by the individual (meaning you).
All contributions are made by the individual, meaning your employer will not contribute.
Employer-sponsored retirement program
Both you and the employer (if your employer provides Roth 401(K) matching) are able to contribute.
Taxes and Investment Options Before Withdrawal
401(K) contributions are pretax, meaning the money is deposited before income taxes are deducted from your paycheck.
401(K) can be invested in mutual funds and exchanged traded funds, and any gains on these investments are not taxed.
Roth IRA is after-tax, meaning income taxes are deducted when you receive your paycheck.
IRAs can be invested in a wider range of investment options than 401(K).
Gains are tax free.
Roth 401(K) is after-tax like Roth IRAs.
Roth 401(K), like Roth IRA, can be invested in a larger variety of investment options than 401(K).
Gains are tax free.
Contribution and Income Limits
401(K)
Employee Contribution Limits3
For 2022, contribution limits are:
$20,500 for those under age 50.
$27,000 for those 50 and older (along with a catch-up 4 contribution of an extra $6,500).
For 2022, the total contribution limit which includes both the employee’s and employer’s contribution are:
$61,000 for those under 50.
$67,500 for those older than 50, (along with a $6,500 catch-up contribution).
All of your salary if it is under the limits above (depending on age).
Roth IRA
Income Limit
Roth IRA has an income limit, meaning in order to contribute a Roth IRA you must make less than $129,000.
For those married filing jointly, you can contribute $204,000.
If you make between $129,000 and $144,000 your contributions will be reduced or phased out.6
For those married filing jointly, contributions between $204,000 and $214,000 will be reduced or phased out.
Those making more than $144,000 cannot make any contributions to a Roth IRA.
$6,000 for those under age 50.
$7,000 for those 50 and older, including a $1,000 catch-up contribution.
Roth 401(K)
Income Limit
No income limit.
Same as 401(K).
Withdrawals
401(K)
Withdrawals from a 401(K) at retirement age (59 1⁄2 ) are taxed as ordinary income when you file your tax return.
Early withdrawals incur a 10% penalty in addition to income tax when you file your tax return.
However there are a number of exceptions, see here.
Roth IRA
Withdrawals are not taxed once the individual reaches age 59 1⁄2.
Early withdrawals incur a 10% penalty on your earnings
The contribution portion of your Roth IRA will remain untaxed.
Roth 401(K)
Withdrawals are not taxed once the individual reaches age 59 1⁄2 and made their first contribution at least five years earlier.
The funds would go to the beneficiaries on the account if the account holder becomes disabled or passes away.
Early withdrawals are subject to penalties and taxes on the earnings portion of your withdrawal.
Required Minimum Distributions (RMD)
401(K)
An individual 72 years or older must withdrawal a minimum distribution each year based on the balance of their IRA as of December 31st of the prior year.
Failing to withdraw the RMD for the full amount results in a 50% tax on the amount not withdrawn to meet the full RMD amount.
This penalty may be waived if the owner establishes that the insufficient RMD amount was not withdrawn due to a reasonable error and steps are being taken to fix the shortfall.
Roth IRA
No RMDs while owner is alive.
Roth 401(K)
Conclusion
Use this information to prepare intelligent questions for your employer, tax professional, and/or financial planner. It is also important to consider which retirement options your employer provides in order to make the most beneficial contributions to your retirement savings.
In the interest of time and space, the next article will cover the pros and cons of each retirement investment option, and what experts believe are the best option(s) in certain situations.
Disclaimer: This is not professional and/or financial advice. This content is for informational purposes only. Before making any financial decisions you should do your own research, evaluate your financial situation, and/or consult a financial professional.
It is important to note that not all situations are mentioned in this article. Please make sure to consult a tax or financial planning professional before making any retirement decisions.
“The average employer match is 4.7% of an employee’s salary.” See, Human Interest.
“For 2021, the IRS limits the amount of compensation eligible for 401(k) contributions to $290,000. For 2022, the limit increases to $305,000. The IRS adjusts this limit every year based on changes to the cost of living… That income limit doesn't mean anyone making over $290,000 in 2021 (or $305,000 in 2022) is ineligible to contribute. It only means any amount of compensation above the limit isn't eligible for contribution.” See, Motley Fool
A contribution made by a participant age 50 or older that exceeds the regular compensation limit. Basically, this is to help those who want to increase their 401(K) contribution as they grow closer to retirement. See, IRS
“The employer match doesn’t count toward your contribution limit, but the IRS does cap the total amount that can go into your 401(k) each year (your contributions plus the match).” See,Investopedia
Please see Publication 590-A provided by the IRS to learn more about phase out ranges.