401k vs. Roth IRA: Which One Should You Choose?
JA
Summary:
Both 401(k)s and Roth IRA accounts are popular choices for retirement savings. A 401(k) is a workplace retirement plan set up by your employer, while a Roth IRA is an individual retirement account that you set up yourself. Both a Roth IRA and a 401(k) offer tax advantages on investments, so which one is right for you will largely depend on whether you’d rather pay income tax on your money after you withdraw it or let your investments grow tax-free.
When considering retirement plans, the first two options that come to mind are usually 401(k)s and Roth IRAs. According to a 2021 survey of income and program participation by the U.S. Census Bureau, in 2020, 34.6% of working-age individuals had a 401(k) and 18% had an IRA. If you’re trying to decide whether a 401(k) or a Roth IRA is the better retirement plan for your needs, you’re not alone; these accounts offer similar benefits, and trying to decide between them can leave your head spinning!
When comparing a 401(k) and a Roth IRA, understanding how they work and familiarizing yourself with their pros and cons can make all the difference in planning your future finances. Let’s take a closer look at the details of both investment choices to help you decide which is the better fit for your unique circumstances and financial goals.
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How does a 401(k) work?
A 401(k) is an employer-sponsored retirement plan that allows you to set aside a portion of your salary and invest it for future use. Whenever you contribute money to your 401(k), you’re putting in pre-tax income, which means contributions are taken out of your paycheck before income taxes have been calculated. You’ll only pay taxes on this money when you withdraw it later on.
Many employers will match your contributions up to a certain amount to help incentivize saving for retirement. A common employer match is 50% of an employee’s contributions, up to 6% of their salary. Since this employer match is essentially free money, you should always take advantage of this benefit if your workplace offers it.
Contribution limits on a 401(k)
The following are the contribution limits on a 401(k) that you should be aware of:
- Employees can contribute up to $20,500 in 2022 and $22,500 in 2023 to their 401(k)s.
- Employees over the age of 50 can make a catch-up contribution of $6,500 in 2022 and $7,500 in 2023.
- The total contributions by an employer and an employee should not exceed $61,000 in 2022 ($67,500 with catch-up contributions).
- The total contributions by an employer and an employee should not exceed $66,000 in 2023 ($73,500 with catch-up contributions).
Distribution (withdrawal) rules on a 401(k)
You cannot let the funds in your 401(k) account sit forever just to avoid incurring taxes upon withdrawal. According to the Internal Revenue Service (IRS), you must take required minimum distributions (RMD) from your 401(k) when you reach the age of 70 1/2 years. If you don’t do so, you’ll face a steep penalty of up to 50% of the amount not withdrawn.
Also note that if you withdraw money from your 401(k) before you turn 59 1/2, you’ll face a 10% early-withdrawal penalty on top of paying taxes on that amount.
Pro Tip
Figuring out the rules for required minimum distributions can feel overwhelming. Thankfully, the IRS has compiled an extensive FAQ that should help you figure out everything you need to know. There, you’ll find answers to common questions, such as how to calculate your RMD and what happens if you withdraw more than the RMD.
How does a Roth IRA work?
A Roth IRA is an individual retirement account that also offers tax advantages, but it works slightly differently than a 401(k). For starters, the account is set up by you instead of an employer. Also, instead of pre-tax dollars, the contributions you make to a Roth IRA are made with after-tax dollars.
Though you cannot get an immediate tax break for your Roth IRA contributions, the money grows tax-free over time. Additionally, any qualified withdrawals you make in retirement are also tax-free. This means that even though your current contributions won’t lower your taxable income, you’ll enjoy the tax benefits in your golden years.
While 401(k)s are usually offered by employers, a Roth IRA can be opened at most brokerage firms or banks. The only catch is that not everyone is eligible, since you must meet certain income requirements. In 2022, if you’re a single filer, you can’t make contributions to a Roth IRA if you earn more than $144,000 ($153,000 in 2023). For married couples filing jointly, the income limit is $214,000 ($228,000 in 2023).
Contribution limits on a Roth IRA
The following are the contribution limits on a Roth IRA that you should know:
- You can contribute $6,000 in 2022 and $6,500 in 2023 if you’re younger than 50.
- You can contribute $7,000 in 2022 and $7,500 in 2023 if you’re 50 or older.
Note that the IRS will impose a 6% tax on excess contributions for each year the extra funds remain in your account. To avoid accumulating hefty charges, withdraw any excess contributions (including interest earned on those contributions) as soon as possible.
Distribution (withdrawal) rules on a Roth IRA
You can withdraw the contributions you’ve made to your Roth IRA any time of the year without incurring taxes or penalties. In other words, you can take out the exact amount you’ve put into your account without a problem.
That said, withdrawing the earnings on your contributions is another story. To make a tax-free and penalty-free qualified distribution of your account earnings, you must be 59 1/2 or older and have had the Roth IRA account for at least five years.
Pros and cons of a 401(k)
Before enrolling in a 401(k) plan through your employer, it’s worth weighing the pros and cons of this type of retirement savings account:
Pros of a 401(k)
- Employer match: Perhaps the biggest perk of a 401(k) account is having the option to take advantage of an employer match. Not only does this benefit accelerate your savings rate, but it essentially provides free money to help grow your nest egg quickly.
- Tax savings: Since the funds invested into your 401(k) account are pre-taxed, they reduce your taxable income and lower your tax liability. If you’re in a high tax bracket, taking advantage of a 401(k) account can save you huge chunks of change during tax season.
- Higher contribution limits: You can contribute up to $20,500 in 2022 and $22,500 in 2023 to your 401(k) account. This contribution limit is significantly higher than that of a Roth IRA.
- Loan option: Some 401(k) plans allow you to borrow from your account balance, giving you quick access to funds when needed.
Cons of a 401(k)
- Limited investment options: Most 401(k)s only offer ETFs and mutual funds, which can limit your investment choices, especially if you’re an ambitious investor who values the freedom of more diverse options.
- Limited access to funds: You typically need to pay a 10% penalty if you withdraw funds from your 401(k) plan before the age of 59 1/2.
- Required minimum distributions: After reaching age 70 1/2, you’re obligated to start taking regular distributions from your 401(k), or else you’ll face hefty penalties.
Pros and cons of a Roth IRA
Like a 401(k), a Roth IRA has its own pros and cons. Here are some of the advantages and downsides to consider:
Pros
- Tax-free withdrawals: Since your Roth IRA contributions are made with after-tax dollars, you won’t have to pay taxes on them again upon withdrawal. This means that your hard-earned savings can go further, as they’ll enjoy tax-free growth until you finally need to use them.
- No early withdrawal penalties on contributions: Unlike with a 401(k) plan, you can withdraw the contributions to your Roth IRA at any point without paying penalties. Keep in mind, however, that you will incur penalties if you withdraw the earnings on your contributions before you reach the age of 59 1/2.
- More investment options: Because Roth IRA accounts are offered by multiple different brokerages and banks, you can find the investment options that best suit your needs.
- No required minimum distributions: Since your Roth IRA contributions have already been taxed, there are no required minimum distributions, so you can leave the funds in your account for as long as you live.
Cons
- Lower contribution limits: Compared to 401(k)s, the contribution limits for Roth IRAs are much lower. In 2023, you can only contribute $6,500 if you’re younger than 50 and $7,500 if you’re 50 or older.
- Income limitations: You can’t contribute to a Roth IRA if your income exceeds the Roth IRA limitation — $144,000 ($153,000 in 2023) for single filers and $214,000 ($228,000 in 2023) for married couples filing jointly.
- No short-term tax advantages: Because contributions to a Roth IRA account are made after taxes, they won’t decrease your current tax liabilities.
FAQ
Is a Roth IRA or 401(k) better?
Neither is inherently better than the other; rather, each comes with unique perks that can be beneficial depending on your financial situation and goals. With a Roth IRA, you have more flexibility in investment options and withdrawals, while with a 401(k), you gain access to your employer’s matching program and higher contribution limits. Ultimately, it’s worth researching both options before deciding which makes the most sense for you.
What are the tax advantages of Roth IRAs and 401(k)s?
Roth IRAs allow you to contribute money that has already been taxed, so you can withdraw these funds without an additional tax burden down the line. Contributions to a 401(k), on the other hand, are made with pre-tax money, meaning that you don’t have to pay taxes on those contributions when you make them; instead, you’re only taxed upon withdrawal.
Should you have a 401(k) and a Roth IRA?
If you expect to be in a lower tax bracket during your retirement years than the one you’re currently in, then contributing more of your savings into a 401(k) plan might make more financial sense. On the other hand, if you believe your tax bracket will stay constant or go up over time, you might want to consider putting more of your resources toward a Roth IRA.
Keep in mind that you’re allowed to have both a Roth IRA and a 401(k), provided that you meet the eligibility requirements for both retirement accounts. If you can do so, contributing to both accounts will allow you to take advantage of tax savings in both the short and the long term.
What are the major differences between a Roth IRA and a 401(k)?
There are three major differences between a Roth IRA and a 401(k). First, there’s the tax treatment of each type of investment. With a 401(k), your contributions are made with pre-tax dollars, which means you don’t pay taxes on that contribution amount until you make withdrawals. With a Roth IRA, your contributions are made with after-tax money, so you don’t have to pay taxes upon withdrawal.
Another major difference between the two accounts is that Roth IRAs offer more investment options than 401(k)s, thus giving you a better opportunity to diversify your portfolio.
And finally, Roth IRAs give you more flexibility when it comes to withdrawals. With a 401(k), you’ll pay penalties for withdrawing your funds before the age of 59 1/2, but there’s no penalty for doing so with a Roth IRA — as long as you’re withdrawing only your contributions and not the earnings on those contributions.
What is the downside of a Roth IRA?
Here are a few downsides to investing in a Roth IRA:
- You can’t contribute directly to a Roth IRA if your income exceeds a certain amount.
- The maximum contribution to a Roth IRA is only $6,500 in 2023 ($7,500 if you’re 50 or older).
- You pay taxes on your contributions upfront, which wouldn’t make financial sense if you are currently in a higher tax bracket.
Key Takeaways
- Both Roth IRAs and 401(k)s offer tax advantages for retirement savings. Which one is better for you will depend on your financial situation and your retirement plan.
- Contributions to 401(k)s are made with pre-tax dollars and can lower your tax liability by reducing your taxable income. Employees can contribute up to $20,500 to their 401(k) plan for 2022 and $22,500 for 2023.
- Contributions to Roth IRAs are made with after-tax dollars and can be withdrawn at any point without incurring penalties. You can contribute $6,000 in 2022 to your Roth IRA ($6,500 in 2023) if you’re younger than 50 and $7,000 in 2022 ($7,500 in 2023) if you’re 50 or older.
- If you want to take advantage of a lower tax liability and an employer match program, a 401(k) may be better for you. On the other hand, if you’d rather diversify your portfolio and let your money grow tax-free, you may want to opt for a Roth IRA.
Roth IRAs and 401(k)s offer similar advantages, but they have some significant differences. That’s why it’s important to consider your current financial situation and long-term goals before choosing one over the other. If you’re still unsure which option is right for you, SuperMoney can help. Start by reading our guides on retirement planning and choosing a financial advisor, then use our comparison tool to find a wealth management firm that will meet your individual needs!
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