Roth IRA vs. 401(k): A Guide for Anyone Who Wants to Retire Someday
When you’re trying to decide between a Roth IRA vs. 401(k), the personal finance gods often have an easy answer for you: Do both, they decree.
Well, that’s easy if you’re swimming in so much cash that you can go on a retirement savings binge — yet don’t earn enough to disqualify you from contributing to a Roth IRA.
In 2023, someone under age 50 would need to contribute $29,000 to reach the limits for both retirement accounts. Mere chump change, right?
We get it: Most of us don’t have the resources to max out both a Roth IRA and a 401(k).
So when you decide how to allocate your retirement dollars, you have to make tough choices.
What Is a Roth IRA?
A Roth IRA is a type of individual retirement account. That means you, Dear Reader, as an individual, open the account and decide how to allocate your investments.
What makes a Roth IRA unique compared with 401(k)s is that you fund it with money you’ve already paid taxes on. That means that when you withdraw it, typically once you’ve reached age 59 ½ and have had the account for at least five years, the money is yours tax-free.
Another sweet feature of Roth IRAs: While you generally have to wait to access your earnings, your contributions are yours to take at any time. While we’d never recommend taking money out of a retirement account unless absolutely necessary — and no, a dream wedding or vacation doesn’t count — your Roth IRA contributions can be a source you tap in an emergency.
What Is a 401(k)?
A 401(k) plan is a retirement account that’s sponsored by an employer. You can’t open a 401(k) on your own.
Unlike a Roth IRA, a traditional 401(k) is tax-deferred. That means you invest part of your paycheck before you’ve paid taxes on it and then pay taxes when you withdraw money in retirement.
A growing number of companies are now offering a Roth 401(k) option, which shares most of the same rules as a traditional 401(k) but is funded like a Roth IRA, with money that’s already been taxed. However, any employer match will be made on a pre-tax basis, and you’ll still owe taxes on that money when you withdraw it.
What makes a 401(k) — either kind — especially attractive is that many employers will match your contributions — in whole or in part — up to a certain percentage of your earnings.
Whatever the amount, it’s basically free money to pad your retirement savings.
Roth IRA vs. 401(k): The Ultimate Showdown
At this point, the Roth IRA vs. 401(k) question is probably sounding complicated, because they both have some pretty sweet features. Now let’s see how they compare across six categories.
1. Who’s Eligible?
While anyone can open a regular taxable brokerage account, not everyone can open a Roth IRA or 401(k). Here are the requirements.
You don’t need a traditional job to contribute to any type of IRA, but you do need taxable income. A salary, wages, tips, bonuses, and freelance and self-employment income all count. If you’re married but don’t work, your spouse can also set up a spousal Roth IRA for you.
While you can fund a traditional IRA no matter how much you earn, a Roth IRA has income limits. (We’ll get to the contribution limits next.)
For people who are single, head of household or married filing separately and didn’t live with your spouse at any point in the year, the Roth IRA income limits in 2023 are:
- If your income is under $138,000 ($129,000 in 2022), you can contribute the maximum amount.
- If your income is between $138,001 and $152,999 ($129,001 to $143,999 in 2022), you can contribute an amount that becomes gradually less the higher your income.
- If your income is $153,000 or higher ($144,000 or higher in 2022), you’re not eligible.
If you’re married filing jointly:
- If your combined income is under $218,000 ($204,000 in 2022), you can contribute the maximum amount.
- If your combined income is between $218,001 and $227,999 ($204,001 to $213,999 in 2022), you can contribute an amount that becomes gradually less the higher your income.
- If your income is $228,000 or higher ($214,000 or higher in 2022), you’re not eligible.
If you’re married filing separately and lived with your spouse at any point in the year, the Roth IRA income limit is $10,000, with no phaseout above that.
To contribute to a 401(k), you have to work for an employer that offers a 401(k). However, your employer can exclude you from participating in its 401(k) for certain reasons, such as if you’re under 21 or have worked for the company for less than a year.
Unlike a Roth IRA, a 401(k) has no income limits.
2. How Much Can You Contribute?
Both a Roth IRA and a 401(k) have limits on how much you can contribute — but the limits are much higher for a 401(k).
The maximum contribution for 2023 is $6,500 if you’re under age 50, or $7,500 if you’re 50 or older. In 2022, these limits were $6,000 and $7,000, respectively. The limits are the same for traditional IRAs. Note that if you have both a Roth and traditional IRA, your total contributions to both accounts can’t be higher than $6,500, or $7,500 if you’re over 50.
In 2023, you can contribute up to $22,500 to your 401(k) if you’re under 50, or $30,000 if you’re 50 or older. The 2022 limits are $20,500 for workers who are younger than 50 and $27,000 for those who are 50 and older.
The total maximum that can be contributed to your account in 2023 is $66,000 ($61,000 in 2022), or 100% of your salary, whichever is less. These limits don’t include the extra $7,500 catch-up contribution people 50 and older can make in 2023 ($6,500 in 2022). So if you’re younger than 50 and putting in your allowed limit of $22,500, your employer can contribute up to $43,500. But hold up, money bags: The most common employer match is 50% of your contributions up to 6% of your salary.
Your employer may also make you wait to access the money it’s putting in your account, which is known as vesting. The money you contribute will always be yours, but if you leave your job before the vesting period is up, you may not be able to take the money your employer matched with you.
3. How Do the Tax Breaks Compare?
Taxes are a major factor when you’re considering a Roth IRA vs. 401(k). Here are some key differences in how the accounts are taxed.
If you were hoping to beef up your tax refund, a Roth IRA will leave you disappointed. But remember: Once you withdraw that money at age 59 ½, as long as you’ve had the account for at least five years, it’s all yours tax-free. You can access the contributions (but not the earnings) at any time without owing taxes or penalties.
Suppose you earn $50,000 and contribute $5,000 to a traditional 401(k). Your taxable income for the year is now $45,000. Because you get the tax break upfront with most 401(k)s, you’ll pay taxes when you withdraw your money.
If you expect to pay taxes in a higher bracket once you reach age 59 ½ or if you think tax rates in general will increase, maxing out your Roth IRA is smart because you lock in a lower tax rate.
4. How Do You Invest?
A Roth IRA will give you more flexibility to choose your own investments, but a 401(k) gets points for convenience.
You can open a Roth IRA through a brokerage firm or a robo-investing service. You could set it up in person if you opt for a brokerage with a brick-and-mortar location or by applying online.
You can invest your Roth IRA money however you want — in mutual funds, ETFs, individual stocks, bonds and annuities.
If you prefer to choose your own investments, you’ll want to open a brokerage account. Consult with a financial adviser if you aren’t sure what investments to choose. If you prefer a set-it-and-forget-it approach, you’ll probably prefer a robo-adviser, which uses super-smart software, instead of humans, to manage your investments.
You can set up automatic transfers from your bank to make investing more convenient.
If your employer offers a 401(k), you may have to sign up for it or you may be automatically enrolled. Most companies let you enroll when you’re hired, though some smaller companies will make you wait as much as a year.
Once you’ve signed up, you’ll have to decide how much to invest and what you want to invest in. Your investment options will be limited compared with your options for a Roth IRA, but you can usually choose from several categories of mutual funds.
You can change the amount you’re contributing and your investment allocations at any time.
Find lower-cost mutual fund options by checking the fee disclosure statement, which your 401(k) plan is required to send you every year.
5. When Can You Withdraw Your Money?
Your retirement accounts aren’t supposed to be a source of quick cash, so the rules around withdrawing money can get complicated.
In general, the IRS lets you withdraw from both plans without penalty if you experience certain hardships, such as if you become permanently and totally disabled, or if you have out-of-pocket medical expenses that are more than 10% of your gross adjusted income.
As we said earlier, one of the biggest benefits of a Roth IRA is that you can withdraw your contributions at any time. That can make a Roth IRA a good safety net in case of an emergency.
That said, you’ll typically have to wait until you’re age 59 ½ and you’ve had your account for five years to withdraw your earnings. Otherwise, you’d owe ordinary income taxes on your earnings and pay a 10% penalty, according to the Roth IRA rules.
You may be able to withdraw up to $10,000 from your Roth IRA, tax- and penalty-free, if you use it for a down payment or other expenses related to a home purchase — as long as your account is at least 5 years old.
You can withdraw your Roth IRA earnings early and use them for educational expenses for you, your spouse or your child, for unreimbursed medical expenses above 7.5% of your adjusted gross income, and some other IRS-approved circumstances, but you’ll still owe income tax.
If you leave your job for any reason between ages 55 and 59 ½, you can withdraw money from that employer’s 401(k) — but not 401(k)s from past jobs — without penalty. But remember: Unless it’s a Roth 401(k), you’ll always pay taxes on 401(k) withdrawals.
After age 59 ½, you can start making 401(k) withdrawals without paying penalties, though most employers won’t allow you to make withdrawals while you’re currently working there.
Early 401(k) withdrawals usually come with a 10% penalty, along with income taxes.
6. Do You Have to Take Distributions?
A required minimum distribution, or RMD, is IRS lingo for when you’re required to withdraw money.
We know it sounds weird that you’re required to withdraw your own money. But remember: Traditional IRAs and 401(k)s are funded with money that has not been taxed. The government wants to make sure it gets its cut.
Here are the basics for Roth IRAs and 401(k)s.
While 401(k)s and traditional IRAs have mandatory withdrawals called required minimum distributions (RMDs), you never have to take money out of your own Roth IRA. After you die, however, your beneficiaries will probably have to take RMDs on the account.
The IRS typically requires that you take distributions beginning April 1 of the year after you reach age 72, and continuing Dec. 31 every year. But if you’re still working, you may not have to. The exact amount depends on your account balance and life expectancy.
Recap: Roth IRA Pros and Cons
Now that you know the basics of Roth IRAs, it’s quiz time. Kidding. But let’s review the basic pros and cons of a Roth IRA.
Roth IRA Advantages
- You get a tax-free source of income in retirement.
- You have control over how your money is invested.
- You can access your Roth IRA contributions at any time, making it a good safety net.
- It’s a convenient way to save for retirement if you don’t have access to a 401(k) or another employer-sponsored retirement plan.
- You can withdraw up to $10,000 of earnings for a home purchase.
- You may be able to withdraw your earnings early for certain medical or education expenses.
- There are no RMDs.
Roth IRA Disadvantages
- You don’t get a tax break upfront.
- You’ll pay income taxes and a 10% penalty in most cases if you withdraw your earnings when your account is less than 5 years old.
- It isn’t an option for many people with high incomes.
- You can only contribute $6,500 for the year, or $7,500 if you’re over age 50 in 2023.
- It’s less convenient than a 401(k) because you’re responsible for managing the account.
Recap: 401(k) Pros and Cons
Now, let’s summarize the good and the bad for 401(k)s.
- You get an upfront tax break with a traditional 401(k).
- Many employers will match your contributions.
- You can contribute regardless of your income.
- The contribution limits are higher than Roth IRA limits.
- It’s a convenient way to invest because your employer manages the account.
- You’ll owe income taxes when you withdraw your money.
- You have fewer investment options.
- You can’t open a 401(k) if your employer doesn’t offer one, and things can get tricky if you leave your job.
- You can’t access your contributions at any time.
- You’re required to take distributions at age 70 ½.
Which Retirement Account Is Right for You?
If your employer offers a 401(k) and offers a match of any kind, your No. 1 priority should be to contribute enough to max out your employer match. Otherwise, you’re missing out on free money.
Once you’ve contributed that amount, putting any excess retirement funds into a Roth IRA could be a better bet because you’ll get the certainty of knowing how much you’re paying in taxes. There’s a good chance you’ll need the tax break even more when you’re on a retiree’s fixed income than you do now.
If you have even more to contribute after maxing out your Roth IRA, you can put it in your employer’s 401(k) to contribute beyond the matched amount.
If you don’t have access to a 401(k) or your employer doesn’t match funds, maxing out your Roth IRA should be your top goal. If you can invest more than the max, you can put your excess funds in your unmatched 401(k) or a regular investment account.
Regardless of whether you prioritize a Roth IRA or 401(k), these are the most important rules for saving for retirement: Start early. Don’t stop. And watch that money grow.
Robin Hartill is a senior editor at The Penny Hoarder.