Retirement account options can be confusing. Should you make contributions before paying taxes (aka 401k) or after taxes (aka Roth IRA)? Why are there different contribution limits? Which one is better?
When thinking about retirement accounts, there a few big ideas at play.
1. You want as much money as possible in tax advantaged accounts. If it is growing at 10%, then having $100,000 vs $1,000,000 means you will make $10,000 vs $100,000 yearly. A big difference!
2. The government doesn't want you to just keep money growing tax free because they want it to run the country. Therefore, the government imposes required minimum distributions (RMD) which forces you take the money out of the tax advantaged accounts or pay a penalty. Once the money is out of the account, the government will tax it through sales tax, capital gains tax, etc.
There is some debate about whether the 401k or the Roth IRA is better based on present vs future income brackets. However, I am going to focus on the differences between the two accounts when it comes to RMDs.
As most people know, 401k dollars are taxed when you withdraw the money in retirement. The downside of the 401k is that you must take RMDs once you turn 72 years old. Essentially, the IRS forecasts the average life of a retiree and creates a table which I show below. The RMD is calculated by taking dividing your 401k account value by the number associated with your age. For instance, say you had $100,000 in your 401k. At 72 years old, you would be required to withdraw $100k/27.4= $3,649 per year but at 76 years old you would be forced to take $100,000/22=$4,545. Eventually your 401k account will be drained so that by the time you die your 401k account will be close to zero and there will be no tax-advantaged dollars left for your heirs. The worst part is that withdrawals from 401k are taxed like the income you make from working so you may fall into higher tax brackets.
The Roth IRA doesn't require you to take RMDs so you could allow it grow tax free until you die. Thereafter you can bequeath your Roth IRA to your heirs and they get to let it grow for another 10 years before they have to withdraw all the money from the tax-advantaged account. In theory, the Roth IRA allows the money to stay in the account longer which makes it more powerful than the 401k. The last few years of compound growth are the most important because your account balance will be the highest and you will make the most! In my opinion that is why the limits of the Roth IRA ($6500) are so much lower than 401k ($22,500) because the Roth IRA is a better retirement account.
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