Among the most popular options in the United States are the 401(k) and Roth IRA plans. Each plan has unique features that cater to different financial situations and goals.
Popular Retirement Plans
The most widely used retirement plans include:
- 401(k): An employer-sponsored plan allowing employees to contribute pre-tax income, often with employer matching.
- Roth IRA: An individual retirement account funded with after-tax dollars, offering tax-free withdrawals in retirement.
- Traditional IRA: Similar to a Roth, but contributions may be tax-deductible, and withdrawals are taxed.
- 403(b): A plan similar to a 401(k), designed for employees of nonprofits and public education organizations.
- SEP IRA and SIMPLE IRA: Retirement plans tailored for self-employed individuals or small business employees.
Among these, 401(k) and Roth IRA are by far the most popular and accessible for the average American worker. Let’s take a closer look at their differences, advantages, and drawbacks.
401(k) vs. Roth IRA: Pros and Cons
Pros of a 401(k):
- Higher contribution limits allow for greater annual savings.
- Employer matching is essentially free money.
- Reduces taxable income in the year contributions are made.
Cons of a 401(k):
- Investment choices are limited and may include high fees.
- Required minimum distributions (RMDs) at age 73.
- Withdrawals are fully taxed in retirement.
Pros of a Roth IRA:
- Tax-free withdrawals in retirement.
- No RMDs, allowing assets to grow indefinitely.
- More control over investment choices.
Cons of a Roth IRA:
- Lower contribution limits.
- No employer match.
- Contributions are not tax-deductible.
Examples
Example 1:
Sarah, a 30-year-old employee earning $60,000 annually, has access to a 401(k) with 5% employer match. By contributing $5,000 per year and receiving an additional $2,500 from her employer, she maximizes both tax savings and employer benefits.
Example 2:
Daniel, 35, is self-employed and prefers long-term tax-free income. He contributes $6,500 annually to a Roth IRA, investing in index funds. Since his income is moderate, he qualifies for full contributions and enjoys tax-free growth.
Case Study: $20K Annual Salary Earner Retiring at 65
Let’s consider Anna, a 25-year-old employee earning $20,000 annually, planning to retire at 65. She can afford to save $2,000 annually. Which plan is better for her?
Given her low income, Anna benefits more from Roth IRA contributions:
- She’s likely in a low tax bracket now, so the immediate tax deduction from a 401(k) is minimal.
- Roth IRA offers tax-free withdrawals, making it ideal if she expects to be in a higher tax bracket in retirement.
- She retains full control of her investments, and no RMDs means she can let the account grow longer if needed.
Assuming an average 7% annual return, Anna’s $2,000 annual contributions to a Roth IRA over 40 years would grow to about $426,000—completely tax-free in retirement.
By contrast, a 401(k) with the same growth would still be taxed upon withdrawal, reducing her net income.
Final Thoughts
Choosing the right retirement plan depends on your income, tax situation, and employment benefits. While 401(k)s are great for high earners and those with employer matches, Roth IRAs offer unmatched tax benefits for younger and lower-income savers. For someone like Anna earning $20,000 per year, a Roth IRA is likely the better long-term choice.
Regardless of income level, the key takeaway is to start early and contribute consistently. Even small amounts, when invested wisely over time, can lead to financial independence in retirement.
