A 401(k) and Roth IRA (as well as the newer SEP IRA) offer tax-free advantages for retirement savings. However, they all differ in their various investment options, tax treatment, and employer contributions. Which is right for you?
Quick Overview of 401(k), Roth IRA, and SEP IRA
Before we discuss the advantages of each type of retirement account, let’s take a moment for a brief overview of what a 401(k), Roth IRA, and a SEP IRA are, what similarities they share, and how they differ from one another.
What Is a 401(k) Plan?
A 401(k) plan is defined as a contribution retirement account. It is typically sponsored by your employer, according to Kasasa. Workers contribute to their 401(k) accounts through automatic payroll withholding, which is a convenient way to save. Employers match those contributions, though the exact percentage varies from business to business. This helps your account grow even faster.
This type of retirement plan offers tax advantages. The contributions and investment earnings won’t be taxed until after the employee withdraws the money, which is typically done after retirement, according to Investopedia.
Employees may be able to pick the investments that make up their 401(k) portfolio, which usually include stocks, bonds, and mutual funds. Typically, financial experts recommend that employees contribute the maximum amount (or close to it) each year.
What Is a Roth IRA?
There are two types of IRAs, or individual retirement accounts. A Roth IRA isn’t that different from a traditional IRA, with one significant distinction: A Roth IRA is funded through after-tax dollars. Therefore, the contributions are not tax-deductible. Conversely, a traditional IRA is funded with pre-tax dollars, which means you gain a tax deduction because you pay income tax when you withdraw the money from your account during retirement.
What Is a SEP IRA?
A SEP IRA is very much like a traditional or Roth IRA, except that it was designed for self-employed souls and small-business owners with few or no employees, Nerd Wallet reports. The “SEP” stands for “simplified employee pension.”
401(k) Accounts: Pros and Cons
Most people saving up for retirement will do so with a 401(k). There are quite a few advantages to using this type of account–but there may be drawbacks as well, depending on your financial situation and goals.
Advantages of 401(k)
Your contributions to a 401(k) are made pre-tax, meaning they are deposited before your income taxes are deducted from your paycheck. If that’s not enough of a reason to look into this popular retirement account option, here are a few more perks.
Employer contribution match: Your employer may offer to match anywhere from 25%, 50%, or even dollar for dollar of what you invest in your 401(k)–up to a set limit. For example, if you contribute $3,000 a year and your employer matches that amount 100%, you end up with a retirement savings investment of $6,000 per year.
Pay lower taxes: On a 401(k), you do not pay taxes on the money until you withdraw it after you retire. The earliest retirement age you can withdraw funds from a 401(k) without penalties is 59 1/2. It is advantageous to pay taxes on the money after you retire because you will likely have a lower income after you stop working full time. That will put you in a lower tax bracket, so a smaller percentage of your retirement savings will go to the IRS if you choose this type of account.
Investment grows tax-free: As long as your money stays invested in your 401(k) plan, it grows tax-free. In that way, your earnings earn more money–and you won’t be taxed on them.
Shelter from creditors: 401(k) savings are protected from judgment creditors by the Employee Retirement Income Security Act of 1974 (ERISA).
401(k) contribution maximum for 2021: The maximum amount the IRS will allow to be contributed to a 401(k) plan is $19,500. However, your employer could set the cap below that amount.
People over 50 can contribute more: People who got started late on retirement savings, don’t lose hope! For individuals over 50 years of age, the IRS allows an additional $6500 per year over the maximum so that they can “catch up” on retirement.
No income limit: No matter how much you make as an individual or as a couple, you are not precluded from investing in a 401(k).
Disadvantages of a 401(k)
No control: Because this account is set up by your employer, you have no control over the plan or the investment cost.
Limited investment selection: Even though you can choose your investments, you have a limited investment selection and mutual funds selected by the plan administrator.
Higher fees: Some 401(k) plans charge higher than average fees.
Early withdrawal penalty: You’ll pay penalties on any money you withdraw before the age of 59 and a half.
Required minimum distributions (RMD): Another downside is the dreaded RMD. Starting in April of the year after your 72nd birthday or the year you retire, whichever is later, the government mandates that you withdraw some of the money from your 401(k). If you don’t, you can be taxed a 50% penalty on the amount of the RMD that was not withdrawn. The amount of your RMD will vary, and the formula is a little complicated. The IRS has a worksheet to help you calculate the amount you must withdraw. You can read about it at here at Investopedia.
Roth IRA Accounts: Pros and Cons
Some people may find that the flexibility and tax model for Roth IRA accounts makes more sense for their goals. Although not as common as a 401(k), there are advantages to choosing this type of retirement savings account.
Advantages of a Roth IRA
A Roth IRA is a good choice if you expect to pay higher taxes in retirement than you are right now. As explained earlier, you are taxed on the money you contribute to your Roth IRA before depositing it into your retirement savings account.
Future withdrawals are tax-free: Because you have already paid taxes on the money you contribute into your Roth IRA account, you pay no taxes on the money you withdraw.
Maximum contribution for 2021: The maximum amount you can contribute to a Roth IRA is $6,000. If you are 50 or older, the limit is $7,000.
Greater investment selections: IRAs offer a choice between stocks, bonds, ETFs, index funds, and mutual funds. That gives you more flexibility to select the type of investment that best fits your needs, according to the Motley Fool.
You can open a spousal IRA: If you’re married but only one of you earns income, you can still open an IRA for the non-working spouse, Investopedia explains. The spouse that is working can contribute to the non-working spouse’s IRA account. Therefore, you can effectively double your yearly contribution, investing $12,000 per year rather than $6,000.
One caveat: The money invested in the spousal IRA belongs to that spouse. Therefore, if you separate or divorce in the future, it’s their money.
Disadvantages of a Roth IRA
No employer match: Unlike a 401(k) plan, this is an individual retirement account. That means you are the only one contributing to it–no matching from an employer.
Taxed at current rate: You pay taxes on the money you contribute based on your current income and tax rate. The advantage of paying taxes on your money after retirement is that if your earnings are less, your tax obligation may accordingly be less. That’s the case for most people, but a financial advisor can help you determine if you would benefit from a Roth IRA.
High earners excluded from Roth IRA: For the year 2021, individual tax filers who earn over $140,000 or married couples who earn over $208,000 are ineligible to contribute to a Roth IRA.
Early withdrawal penalty: Thinking about getting your money out early? Think again. You’ll face a penalty if you attempt to withdraw funds from a Roth IRA before you reach the age of 59 1/2.
SEP IRA Accounts: Pros and Cons
A SEP IRA isn’t for everyone, but if you’re self-employed or own a small business, then it could be the best choice for your retirement.
Advantages of a SEP IRA
There are some advantages to a SEP IRA if you are self-employed or a small-business owner with few or no employees. With this type of plan, you can reduce your taxable income. You can also contribute more than double the amount toward your retirement than you can with a 401(k) and nearly ten times a traditional or Roth IRA.
Increased contributions: With a traditional IRA, you are limited to $6,000 per year. Choosing a SEP IRA, on the other hand, means you can contribute up to $58,000 in 2021.
Contributions are tax-deductible: If you’re self-employed, your deduction is 25% of your net self-employment income. Otherwise, you are able to deduct the lesser of your contributions or 25% of compensation, subject to the compensation cap of $290,000 in 2021, according to Nerd Wallet.
Can be combined with other IRAs: You can combine a SEP IRA with a traditional IRA or Roth IRA.
Greater investment selections: IRAs, including SEP IRAs, offer a choice between stocks, bonds, ETFs, index funds, and mutual funds, so you can choose the mix that best fits your needs, according to the Motley Fool.
Disadvantages of a SEP IRA
No catch up for age 50+: Unlike a traditional or Roth IRA, there is no extra “catch up” amount for people who are 50 or older.
Matching contributions for eligible employees: If you have employees, then plan to spend more money. Whatever you contribute for yourself, you are required to match proportionately for your employees.
Early withdrawal penalty: As with other retirement accounts, if you try to withdraw from your SEP IRA before you are 59 1/2, you are subject to a 10% penalty. However, you might meet early withdrawal exceptions, so read on to see if you can withdraw the money without a penalty.
Exceptions for Early Withdrawals
All of the retirement accounts listed above (401(k), Roth IRA, SEP IRA) are subject to penalties for early withdrawal. However, there are exceptions to the rules. You may not have to pay penalties if the money is used to pay for any one of the following:
- Unreimbursed medical expenses.
- To pay for medical insurance.
- For tempered higher education expenses.
- For childbirth or adoption expenses.
Keep in mind that within all of the above exceptions, there are further qualifications and limitations. This is an area where you should discuss your options with a qualified financial advisor.