Both 401(k) plans and Roth IRAs offer tax-sheltered growth for money in your retirement account. However, the two plans have significant differences when it comes to other aspects of the plans. Making the right decision as far as how best to fund your retirement-account options can save you thousands of dollars.
How to Fund the Accounts
In order to add money to a 401(k) plan, you have to do so with deferrals from your paycheck. You inform your employer of the amount of money that you want taken out of your paycheck to go into the account and then your employer deducts it from your paycheck and puts it straight into the 401(k) plan. With a Roth IRA, you have to make the contributions on your own. You can do so with a lump-sum contribution or you can spread your contributions out over the year if you prefer.
To contribute either a 401(k) or a Roth IRA, you must have taxable compensation for the year. A 401(k) plan requires that you be employed by the company offering the plan, but does not impose income restrictions. Anyone with a modified adjusted gross income below the yearly limit can contribute to a Roth IRA. For example, in 2011, you cannot make any contribution to Roth IRA if you are single and have a modified adjusted gross income over $120,000, if you are married filing jointly and have a modified adjusted gross income over $177,000 or if you are married filing separately if you lived with your spouse at all during the year with a modified adjusted gross income over $10,000.
Yearly Contribution Limits
A 401(k) plan not only allows you to put in more money each year than a Roth IRA, it also permits your employer to make contributions on your behalf. A Roth IRA does not accept contributions from your employer. As of 2011, you can defer $16,500 into your 401(k) plan ($22,000 if 50 or older), and the total of your contribution and your employer's contribution cannot exceed $49,000. With a Roth IRA in 2011, you can only put in $5,000 ($6,000 if 50 or older).
A significant difference between funding a 401(k) plan and a Roth IRA is the tax benefits each offers, both in the year you fund the the account and the year you remove the money. Money used to fund a 401(k) plan does not count as taxable income for that year. For example, if you make $39,000 and contribute $4,200 to your 401(k) plan, you report only $34,800 on your taxes. You do, however, pay takes when you take money out of your 401(k) plan. Conversely, the Roth IRA contributions do not lower your income taxes, but when you take qualified distributions from your Roth IRA, the money comes out tax-free.
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