This story is part of CNBC Make It’s One-Minute Money Hacks series, which provides easy, straightforward tips and tricks to help you understand your finances and take control of your money.
If you’re thinking about starting to save for retirement, chances are good that you are looking at both Roth IRA and 401(k) plans. Both offer tax benefits and can help you grow your wealth over time, but there are several key differences between the two. The biggest one? When you want to pay taxes — now or later.
If you have access to an employer-sponsored 401(k) account, you pay taxes when you withdraw your earnings in retirement at whatever rate your tax bracket is at the time. The account is funded with pre-tax dollars diverted from your paycheck by your employer, which lowers your taxable income each year that you contribute.
Roth IRAs, on the other hand, are funded with post-tax dollars, so the money grows tax-free. You can also withdraw your contributions at any time (but not your earnings) with no tax penalty, unlike 401(k)s which typically hit you with a 10% penalty if you access any of the money early.
Many employers offer to match a certain percentage of employee 401(k) contributions, effectively doubling a portion of your investment each pay period for free. If your employer offers a contribution match, don’t leave any money on the table.
“We always encourage people to contribute enough to get the maximum employer contribution,” says Sarah Hampton, co-founder and partner at wealth management firm 6 Meridian.
The maximum amount workers under 50 can put in their 401(k) in 2021 is $19,500. Those 50 and older can also put in an additional $6,500 in catch-up contributions. With Roth IRAs, investors younger than 50 are limited to contributing $6,000 in 2021, and those 50 and older can contribute an additional $1,000.
“Contribute early and often, because you can’t catch up later,” Hampton says of 401(k) plans. “Once the calendar year is gone, you can’t go back.”
When it comes to the control you have over your money, 401(k)s limit you to pre-screened funds that have been approved by your employer’s plan, whereas a Roth IRA gives you a wider range of options including stocks, bonds, ETFs and index funds.
However, if you can afford it, Hampton recommends contributing to both a 401(k) and a Roth IRA. “You get a more tax-favorable outcome this way,” she says. “Your Roth IRA and 401(k) can continue to compound their growth on each other, as opposed to having to pay tax as you go.”
No matter what you choose, the earlier you decide to start investing, the better you set yourself up for retirement.
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