401(k) vs. Roth IRA: The Ultimate Challenge
NEW YORK ( MainStreet) For younger professionals who are closer to the beginning of the retirement savings cycle than the end, figuring out how to start saving money begins with figuring out where to start saving the money. After they figure out the savings vehicle, the question is how much they should be saving when retirement seems so far away and their salary can often be fairly modest in the early stages of their career.
"It can be difficult to convince someone who is 25 years old to put money away each month now for something that will not occur in 40 years or longer," says Neal McGrath, a partner with Carson Institutional Alliance in Pittsburgh, Pa. "The importance of having financial independence and the safety of stable benefits in case you lose your job or something happens in retirementthat is so foreign to them."
The first step is to understand the differences between three common savings vehicles: a traditional 401(k), a Roth 401(k) and a Roth IRA. The majority of young professionals who have an employer-sponsored retirement plan will be enrolled in a traditional 401(k), although an increasing number of companies are also adding a Roth 401(k) account to employee options as well.
"As a savings vehicle, they are nearly identical," John Napolitano, chairman and CEO of U.S. Wealth Management in Braintree, Mass, says of the two 401(k) offerings. "It comes down to a tax issue."
The biggest difference between a traditional 401(k) and a Roth 401(k) is that with the former you contribute money tax-free and pay taxes when you make distributions; with the latter you pay the taxes upfront and then make tax-free distributionsalthough if your employer offers a match on the Roth 401(k) then that portion is taxable income. Both vehicles impose a maximum contribution limit of $17,500 annually for people younger than 50.
By comparison, a Roth IRA allows a maximum annual contribution of $5,500 for all people younger than 50. Like a Roth 401(k), taxes are paid upfront and the distributions are made tax-free.
While an IRA has a much lower ceiling in terms of annual contributions, there are a few significant advantages that make it attractive as a savings vehicle for young professionals. For one, a 401(k)both traditional and Rothrequires that the account holder begin making distributions when he or she reaches 70 1/2, while a Roth IRA is free of any distribution requirements.
Although the distribution requirement is fine for people who need this money anyway, it can prove inconvenient for people who are financially secure through inheritance or other means and don't really need to tap into their employer-sponsored account for retirement savings.
"My clients who have wealth outside the 401(k) get upset with the minimum distribution requirements," Napolitano says. "If you don't need the money, you're going regret having to take it out and pay taxes on it."