- How's it goin' today guys?
Welcome back to the channel,
hope you're having a great day so far.
So what we're gonna be talking about in this video today,
is the differences between a 401k and a Roth IRA.
And this is a very important topic
and it's one of these things that's,
these lessons that you're just not learning in school
or learning anywhere else,
and it's extremely important to understand the differences
between these two different types
of retirement accounts out there.
And the other thing I wanna point out here as well,
is people often think that it's one or the other.
You can either have a 401k or you can have a Roth IRA
and that is just not the case, and in fact,
the best strategy, in most cases,
is to be taking advantage of both a 401k and a Roth IRA
and I'm gonna show you guys exactly what
that strategy looks like at the end of this video.
But starting off here, let's talk about the first difference
between these two investment vehicles.
Number one, a 401k is sponsored by your employer,
so you have to be employed
in order to be eligible for a 401k.
So, myself personally, since I'm self-employed,
my company is one person so I don't have a retirement plan,
and so I am not eligible to have a 401k,
unless I set one up for my company.
And in the past, when I did work a job,
when I worked for the utility company,
I did have a 401k available to me.
And the one thing here that's important
to understand is it's not mandatory.
It's optional whether or not you want
to opt-in to that employer 401k.
Now the Roth IRA, on the other hand,
is independent, it's something you go out there
and you set this thing up on your own,
it has nothing to do with your employer
and as long as you're within certain income limits,
anybody out there can open up a Roth IRA.
Second of all, with a 401k,
this is one of the biggest issues with them,
is that you're limited to the employer plan
and 401ks are not all created equally.
There are some 401ks that are really good,
they have great selections for ETFs or funds
and they're low in expenses,
and there are other 401ks out there
that are full of high fee investments
that are just not really a good pick for most people.
And the issue is, if your employer offers a bad plan,
you're pretty much stuck
with choosing something from that plan.
The benefit to a Roth IRA, is that you can go
through any firm or brokerage that offers them,
and with a self-directed Roth IRA,
you can put anything in there.
If you wanna put stocks in there,
if you wanna put the Vanguard 500 Fund,
whatever you wanna put in there,
you choose what goes into that retirement account
and you are tax-sheltered with that investment.
The next difference is with your contributions.
When it comes to your 401k,
you are putting away your pre-tax income.
So before you have a chance to even touch that money,
it comes out of your paycheck off of your pre-tax income.
With a Roth IRA, you're putting away your post-tax income,
and a lot of people say, well, you know,
that's a huge disadvantage, but it's actually not
when you consider the tax implications
of each of these two investment vehicles.
The next difference is a big pro for the 401k.
It's an incentive that some companies are offering
and it's called a company match.
We'll go over an example of what
that looks like in a little bit.
But with a 401k, some employers out there offer a match
to incentivize people to contribute
towards their retirement savings.
So, in my case, when I worked for that utility company,
they would match my contributions, you know,
50 cents out of every dollar up to 6%.
So, if I contributed 6% to my retirement,
they would contribute 3%,
but if I did anything more than that,
they would contribute no more than 3%
of my annual salary as a bonus.
So with the 401k, if your company offers a company match,
you have this possibility here to take advantage
of completely free money being offered by your employer.
The downside to the Roth IRA, there's no match out there.
The government's not gonna match your money,
nobody's gonna give you extra money
to reward you for using the Roth IRA,
so there are no incentives like that.
As far as the 401k goes, there are no income limits
as far as how much money you're making.
You could make $500,000 per year
and still contribute to a 401k.
Now a Roth IRA on the other hand,
there are income limitations where you can't make
more than this amount of money,
and for single filers in 2019 that's 137,000,
and for married that is $203,000.
So if you make over that amount of money,
you can't contribute to a Roth IRA.
The next difference is the amount you
can contribute each year.
With the 401k, for the updated numbers for 2019,
you can contribute up to $19,000
per year of your pre-tax income.
And the Roth IRA, on the other hand, is $6,000 per year,
or $7,000 per year if you're 50 or up,
in what they call a catch-up period,
where you can do more contributions per year.
Now let's talk about the interesting part here,
which is the tax benefits here, all right?
With the 401k, there is a tax benefit
because you're able to reduce your taxable income,
and based on what tax bracket you fall into,
it may be advantageous to contribute extra money
into your 401k to push yourself down a different bracket.
So that is one of the games people play here with the 401k,
is ramping up their contributions
to fall under a certain tax bracket, you know,
to save money by falling into a different bracket entirely.
There are no tax benefits with the Roth IRA,
but there is a major difference in how you are taxed
with both of these investments.
With the 401k, you're paying taxes later
on the growth of that money.
So you don't pay taxes going in,
but you pay taxes once you start to take money
out of that account and redeem that money.
With the Roth IRA, you're paying taxes now,
you're contributing with post-tax income,
but as a result, your money is growing tax-free.
And that can be a huge benefit,
especially for young people, is having decades of growth
and compounding within a Roth IRA,
without ever having to pay taxes,
as long as they wait until 59 and a half years old
to begin withdrawing from that account.
Now another huge difference between these two accounts comes
down to penalties if you decide
to take money out of these accounts.
If you dip into a 401k early, you're gonna get a huge slap
on the wrist and it's going to be painful.
You're going to pay all of the taxes
on all of those contributions plus a 10% penalty.
So, it is not something I would ever recommend doing,
cashing out a 401k early.
I know people that have had to do this
for one reason or another,
and it results in a nasty tax bill at the end of the year.
The advantage to the Roth IRA is
that you can withdraw your contributions
at any point in time,
since you already paid taxes on that money.
And you don't have to pay any taxes
or withdrawal penalties because it's money
that you've already paid taxes on.
So that is one of the benefits to the Roth IRA,
is that, if you put money in there
and down the road you need that money,
you can pull out your contributions any time.
But if you pull out any of the money
from the growth of the account,
that is when you're going to pay taxes,
plus that 10% penalty.
So, in a nutshell, any money you put into your 401k,
you pretty much can't take it out
except for specific use cases.
So if you do think you're going to need that money,
don't put it in your 401k, maybe put it in your Roth IRA,
that way it can grow and down the road you can pull
that money out and pull out your contributions
without paying any kind of taxes or penalties.
And then finally, one of the biggest differences here,
in my opinion with the 401k versus the Roth IRA,
is that it's kind of a hedge against future tax hikes.
So basically, the way tax laws are written right now,
with the Roth IRA, since you've paid taxes already
and you used taxable income,
you're not gonna pay taxes in the future.
With the 401k, you haven't paid taxes on this,
so down the road you are going to pay taxes.
And this comes down to a question of,
do you think taxes are going to be higher
in the future, the same, or lower?
If you think taxes are going to be lower in the future,
then a 401k probably makes more sense
because you can take advantage
of that lower future tax rate.
If you think they're gonna be the same,
there's no real difference here.
But if you think that taxes might be higher,
based on our national debt and all the different,
the problems we have with Social Security, you know,
personally, I believe taxes will be higher in the future.
You can hedge against future taxes by paying taxes now
and not having to pay them later through the Roth IRA.
Now yes, they could change these tax laws
but, the way it stands right now,
you can lock in a lower tax rate today
by using a Roth IRA instead of going through a 401k.
Now as I said earlier in this video,
in most cases it makes sense to use both the 401k
and the Roth IRA and I'm gonna show you guys
exactly why that is right now.
So this is the basic strategy here
that makes sense for most people,
assuming that you don't know what you're looking at,
in terms of your 401k.
If you have no idea if your employer's plan is a high fee
or a low fee plan, this, in most cases, is the best option,
but I would always recommend going out
and talking to a financial advisor
if you have any questions on this
because, making the wrong decisions
across your entire life could cost you
a significant amount of money.
But anyways, number one, the first thing
that makes sense in most cases,
is always maximize employer match.
This is literally free money being offered to you.
A lot of people aren't taking advantage of it,
and so you need to take advantage of that free money
that your employer is offering
through the employer-sponsored contribution or match.
So like I said, in my case at my old job,
I made about $60,000 per year.
I contributed 6% of my pay, or $3,600 to my 401k,
and my company matched me 50 cents on the dollar, up to 3%.
So that 3% earned me an extra $1,800 per year
of completely free money going into my 401k.
So that is usually the best thing to do is maximize
up until what your employer is going to match.
Number two, the second step, is to maximize to a fee free
or a low fee Roth IRA and I'm gonna go through two examples
with you guys at the end of this video
to help you understand the differences
in why you might actually want a low fee
versus a fee free Roth IRA.
And then third and finally,
that is when you would put surplus money
into your savings account for any kind
of major life purchases, for maybe your emergency fund,
and then eventually if you have more money to invest,
that is when you would put that money in a taxable account,
where you're going to be paying capital gains taxes.
A lot of people make the mistake
of skipping step number two entirely.
They contribute to their 401k,
but then they open up a taxable account
instead of a Roth IRA and they're paying taxes
on their gains for pretty much absolutely no reason.
Now, let's go ahead and talk about opening a Roth IRA.
If it's something you're interested in doing,
I have been studying different brokerage accounts
and investing accounts for a couple of years now
and I have a lot of good insight
on some of these different platforms.
Now, I am affiliated with both M1 Finance and Betterment
and I do have links in the description.
So if you use those links,
I do get a kickback or commission.
I just wanna be transparent about that,
but you guys absolutely do not have
to use those links if you don't want to.
It certainly does help me out though and supports my channel
and allows me to make more videos like this.
But starting off with the fee free Roth IRA,
based on all the options I've looked at,
I have found that M1 Finance has basically
the best offerings out there for the free platforms.
You can pick individual stocks,
you can put your money into ETFs,
or you can go and invest in some of their expert pies
and they're all fee free.
You're not paying any expenses to M1 Finance
and in those expert pies, they offer what's called a TDF
or a target date fund, where you basically put
in your target retirement date
and they're going to give you specific investment plans
tailored towards that retirement date.
And that is something that is not being offered
by any other free investing platform out there.
Second of all, you're paying nothing to M1 Finance,
you may pay an expense ratio to the ETFs you invest in,
but you're going to be paying those regardless
of what brokerage account you go through.
And ultimately this means that you're keeping more
of your money invested and ultimately allowing your money
to grow, rather than paying money in unnecessary fees.
And then third of all, the reason why I like M1 Finance is
they have a low minimum of just $500.
And so that is pretty accessible for most people.
So that is, in my opinion, a good free investing platform
and like I said, there is a link in the description
if you wanna watch my full review video on M1 Finance
or open up an account with them.
Now option number two for Roth IRAs is opening
up a low fee Roth IRA and, in my opinion, I think
Betterment is a very solid choice for this.
Now Betterment is offering basically portfolio guidance
or like I like to say, peace of mind for .25% expense ratio
and the benefit to Betterment is that this is going
to be tailored to your goals or your specific needs.
So you'll put right in there, this is what my goal is,
this is when I wanna retire, and the algorithm will build
you a custom portfolio based on those needs.
The downside to going through a free option like
M1 Finance is that those expert portfolios are not tailored
to any one specific person and so you may find
that you get a better built portfolio
by going through a service like Betterment.
And it's a good option aside from going
to an in-person financial advisor,
where you may pay a 1% annual fee or more.
Another benefit to going with a low fee option
like Betterment is that they are going
to automatically rebalance your portfolio
and reallocate your portfolio.
So one of the downsides to going through a free option is
that you're going to have to remember to rebalance
that portfolio if your allocations get out of whack,
and you're gonna also have to remember
to change your allocations because you may not wanna have
all this risk involved with your portfolio as you get older.
So if you're a portfolio junkie and you like investing
and you wanna be an active investor,
you can take advantage of that cost savings
by using a free platform like M1 Finance.
But if you don't know what you're doing
and you don't wanna remember to rebalance your portfolio,
or reallocate it, that is kinda the niche here
that Betterment is filling, and that's at a
very reasonable annual fee here of .25%.
And then the other benefit they offer
here is a tax-coordinated portfolio.
So basically what they're doing is they're taking all
of your different investing portfolios,
and essentially looking at what you're investing in,
and your holdings, and they take any investments
that you're going to pay higher taxes in
and they move those into your Roth IRA,
where you're going to be tax-sheltered.
Now the benefit to this is there is some tax savings
and they have found that, on average,
it boosts your after-tax return by .48% per year.
So when they're charging you .25%
but this benefits you .48, it essentially pays for itself,
if you take advantage of that tax-coordinated portfolio.
And then finally, another reason why I like Betterment,
is they have a $0 minimum to open up a Roth IRA with them.
But anyways guys, that is the difference
between a 401k and a Roth IRA,
and then there's a couple of options there if you're looking
to open up a Roth IRA yourself.
I will link up to all of these resources
in the description below.
But thank you guys so much for watching this video,
I hope you enjoyed it, and I will see you in the next one.