Roth IRA vs. 401(k): Which Is Best for You?

09/05/2024

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Saving for retirement is undoubtedly one of the best financial decisions you can make. But should you choose a Roth IRA or 401(k) plan for your savings? Ideally, having both accounts can provide you with the most benefits in retirement.

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However, if you’re exploring whether you should opt for a Roth IRA vs. 401(k), learning about each plan’s features can help you prepare your finances for a more comfortable retirement.

Roth IRA vs. 401(k): A Quick Comparison

The 401(k) and Roth IRA plans are similar in that they offer tax benefits and will help you grow your wealth over time, but there are key differences.

A 401(k) is an employer-sponsored retirement plan that allows you to invest pre-tax money, providing more money for you to invest before retirement. But you must pay taxes when you withdraw the money for retirement. A Roth IRA is a non-employer-based plan that allows you to invest after-tax dollars. Your qualified Roth IRA withdrawals are tax-free.

What Is a 401(k)?

A 401(k) plan is a retirement savings plan that some U.S. employers provide as an employee benefit. You contribute a percentage or set amount of your pre-tax income and then pay taxes on the money when it’s withdrawn for your retirement.

Advantages of a 401(k)

The following are significant advantages of a 401(k).

Employer Matches

Employers aren’t required to match employee 401(k) contributions, but if your employer does, ensure you take advantage of it. All contributions are yours to keep, even if you leave your job. The match is usually a specific percentage of your contribution or gross income.

For example, your employer might match 100% of your contributions, up to 3% of your salary. If you are able to contribute the full 3%, your employer will essentially double the funds going into your retirement nest egg.

High Contribution Limits

You can contribute up to $23,000 per year to a 401(k), excluding the employer match. If you’re 50 years or older, you can contribute an additional $7,500 a year.

It’s worth noting that you can only contribute up to 100% of your salary. So, if you earn less than $23,000 from an employer in one year, then your contribution limit is equal to your earnings. For example, if you earn $20,000 in a year, then you can only contribute up to $20,000 to your 401(k).

Tax Breaks

Your 401(k) contributions provide you with a tax break, because the money is contributed before your income is taxed, reducing the amount of taxable income. However, the money is subject to income taxes at the tax rate that is current when you take distributions from the plan.

Disadvantages of a 401(k)

While a 401(k) plan is a great option to save for retirement, there are a few drawbacks.

Limited Investment Options

A third-party investor oversees a company’s 401(k) plan. The plan administrator chooses what you can invest in, limiting your options. Depending on your investment options, this could be a significant drawback to your 401(k) plan. But many 401(k) plans have sufficient investment options to build a portfolio that suits your needs.

In addition to limited investment options, the available investments tend to come with relatively high fees attached. Keep that in mind as you build a portfolio within your 401(k).

Required Minimum Distributions

Once you reach age 73, the law requires you to withdraw a certain amount of your 401(k) savings yearly, or you’ll be penalized. And if you withdraw the money before age 59 ½, you’ll incur a penalty. Make sure to read the fine print before attempting to pull any funds out of your 401(k).

What Is a Roth IRA?

A Roth IRA is a retirement plan that allows you to contribute after-tax dollars, thus increasing your investment tax-deferred. It is available to anyone with earned income up to an amount specified by the IRS — which varies by your filing status — so you don’t have to rely on employer involvement to save for retirement.

Advantages of a Roth IRA

You might want to choose a Roth IRA for the following reasons.

Investments Grow Tax-Free

Since you contribute to your Roth IRA with taxed money, the growth isn’t subject to taxation, and you won’t have to pay taxes when making withdrawals at retirement.

More Freedom With Investment Options

Administrators do not dictate the funds you can invest in, meaning you can choose how you want to invest. However, seek advice and understand how different investments work before investing.

Offers Spousal IRA

If you are married, but only one spouse earns an income, the working spouse can also open a Roth spousal IRA for the non-working partner. The earning spouse can invest in both accounts.

Disadvantages of Roth IRAs

You should consider these disadvantages before opening a Roth IRA.

Lower Contribution Limits

When it comes to disadvantages, the low contribution limits is a big one. It only allows contributions of up to $7,000 per year or $7,500 if you’re 50 or older, which is significantly lower than the contribution limits of a 401(k).

No Employer Match

Since you open a Roth IRA without the help of an employer, you won’t have an opportunity to receive matching contributions. If you get an employer match, it’s a good idea to earn those matching funds before funneling your resources into a Roth IRA. If you skip the match, you are essentially leaving free money on the table.

Is a Roth IRA Better Than a 401(k)?

Opening a Roth IRA account is a wise financial move if you’re self-employed or work for a small business with no 401(k) plan.

However, if your employer offers a 401(k), especially if it matches contributions, you should consider enrolling. Not only are the matching contributions essentially free money, but you’ll also have a higher contribution limit than with a Roth IRA.

Your best option is to have both — you can take advantage of the benefits of each while mitigating the drawbacks.

What Age Should You Open a Roth IRA vs. 401(k)?

When it comes to saving for retirement, the earlier you can start saving within a 401(k) or Roth IRA, the better off you’ll be in the long run.

If you start working for an employer that offers a 401(k), consider enrolling right away, especially if you can tap into matching contributions. Setting aside a portion of your paycheck into your 401(k) will help you build the muscle of saving as early as possible.

Whether or not you have access to a 401(k), opening a Roth IRA early is a good idea. As you progress through your career, you can continue to tuck away funds into this important retirement savings account.

Final Take

Roth IRAs and 401(k)s are popular retirement savings plan options since they each provide significant tax benefits. However, they have distinct differences in terms of investment options, tax treatment and employer contributions, which you should carefully consider before choosing one over the other.

Your choice today can help you save thousands of dollars in preparation for your retirement. Ideally, you’ll use both to grow your retirement nest egg.

FAQ

Here are the answers to some questions about contributing to a 401(k) vs. a Roth IRA.

What’s the difference between a Roth IRA and a 401(k)?
- A Roth IRA is a retirement plan that allows you to contribute after-tax dollars, thus growing your investment tax-deferred. On the other hand, a 401(k) is an employer-sponsored plan that allows pre-tax contributions, meaning it will reduce your retirement income.
Can you have a Roth IRA and a 401(k)?
- Yes, you can have a 401(k) plan through your employer and also open a Roth IRA. If you can afford to contribute to both, you certainly should, because you get the benefits of your 401(k) employer match and the Roth IRA tax benefits in retirement.
Should I move my 401(k) to a traditional IRA or Roth IRA?
- You may want to consider rolling your 401(k) into an IRA when you leave the employer providing your 401(k) plan, whether you’re changing jobs or retiring.
- However, to maximize retirement savings and minimize taxes, you should seek professional advice before moving your retirement savings.
Is it better to put money in a 401(k) or Roth IRA?
- Both of these accounts offer a way to save for retirement. You’ll only be able to access a 401(k) if your employer makes that an option. But that doesn’t make a 401(k) better than a Roth IRA. Each account represents an opportunity to build retirement savings. If you have room in your budget, consider contributing to both accounts.
Why is a Roth IRA better?
- A Roth IRA might be considered the better choice because it allows for tax-free growth and withdrawals in retirement. This can be helpful if you expect your tax rate to be higher in the future.
Is a 401(k) better than a Roth IRA for high-income?
- For high-income earners, a 401(k) can be more beneficial due to the higher contribution limits and the potential for employer-matched contributions.
How much should I put in my Roth IRA monthly?
- The amount you should contribute to your Roth IRA monthly depends on your retirement goals and financial capacity. The maximum for 2024 is $7,000 per year if you’re under the age of 50, or $8,000 if you’re 50 or older. Try to contribute as much as you can to maximize your retirement savings.