Both 401(k) accounts and Roth IRAs are popular tax-advantaged retirement savings plans that differ in tax treatment, investment options, and possible employer contributions. It is possible to contribute to both, but contributions have to come from wages & earned income, and not investment or rental income.
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Named after section 401(k) of the Internal Revenue Code, this retirement saving plan is an employer-sponsored deferred-income plan. To contribute to a 401(k), the employee designates a portion of each paycheck to be diverted into the plan. These contributions occur before income taxes are deducted from the paycheck.
The investment options among different 401(k) plans can vary tremendously, depending on the plan provider, but no matter which fund (or funds) the employee chooses for his money, any investment gains realized within the plan are not taxed by the IRS. Taxation only occurs after the employee has reached retirement age and begins to make withdrawals from the plan. These distributions (payments) are subject to income taxes at the retiree's current tax rate.
As of 2019, the limit for annual 401(k) contributions for those under the age of 50 is $19,000, and those 50 and older can contribute an additional $6,000 per year. 401(k) plans are most beneficial when an employer offers a match, contributing additional money to the employee's 401(k) account, usually a percentage of the employee's contribution.
A variation of traditional individual retirement accounts (IRAs), a Roth IRA is set up directly between an individual and an investment firm; the individual's employer is not involved.
Since the account is set up and controlled by the account owner, investment choices are not limited to what is made available by a plan provider. This gives IRA accounts a greater degree of investment freedom than employees have with 401(k) plans, though the fees charged by those providers are typically higher.
In contrast to the 401(k), after-tax money is used to fund a Roth IRA. As a result, no income taxes are levied on withdrawals during retirement. While in the account, any investment gains are untaxed.
The contribution limits are much smaller with Roth IRA accounts. In 2019, the maximum annual contribution for those under the age of 50 is $6,000. People ages 50 and up can contribute an additional $1,000 for a total of $7,000/$6,500 per year.
Roth IRAs make the most sense for individuals who believe they will be in a higher tax bracket when they retire. A Roth IRA has a five-year rule when it comes to withdrawing your earnings. While you can withdraw your contributions at any time or any age, the five-year rule states that you cannot withdraw your earnings for five years from the first tax year of your original contribution to the account. When you turn age 59½ you can access both your earnings and contributions without penalty or paying taxes.