Key Differences Between 401(k)s and Roth IRAs

What Is a Roth IRA?

Roth IRA is an individual retirement account that allows you to save for retirement without paying taxes now. You can withdraw your contributions (not the earnings) at any time, tax-free and penalty-free.

Many employers will sign you up for a Roth IRA automatically if they offer it as an employee benefit, however, there are other ways to set up a Roth IRA. You can contact many banks or investment companies to help you open up your account by sending in the necessary forms.

What Is 401(k)?

401(k) is a retirement savings plan offered by an employer, which allows employees to contribute a portion of their salary on a pre-tax basis.

Any money contributed (and earnings) is allowed to grow tax-deferred until withdrawal. 401(k) plans are subject to annual contribution limits, which vary according to your age and whether or not you set up a 401(k).

The Difference Between Roth IRA and 401(k) 

Both investments allow tax-free growth, however, 401(k) contributions are made on a pre-tax basis, while Roth IRA contributions are made with after-tax dollars. So, you will get it back plus the earnings when you withdraw your money.

Also, 401(k)s are established through employers and can only be funded by salary deferrals (i.e., deductions from your paycheck), whereas Roth IRA contributions can be made through individuals without any income limit or restrictions on how much they contribute.

How to Invest in Either Account 

Investing in both accounts is also very different:

401(k) contributions are made through payroll deductions, whereas Roth IRA contributions can be made directly to the investment account by check or electronic funds transfer.

When you want to withdraw your money from your Roth IRA, there are no penalties or tax consequences, but you’ll still have to pay income taxes on the amount withdrawn. On the other hand, when you want to withdraw your money from your 401(k), there are penalties and you will have to pay taxes.

Considerations When Deciding on a Roth or 401(k) 

Your Current Income Status

If your annual salary is less than $107,000 (married filing jointly) or $72,000 (single), then you should probably choose a Roth IRA.

On the other hand, if your annual salary is higher than either of those values, you might lean towards a 401(k) because contributions will be taxed when withdrawn and only up to $17,500 (or $23,000 if age 50+) can be contributed to a Roth IRA.

How Soon Do You Need the Money

If you are expecting to use your money in the next five years, opt for a Roth IRA because you won’t have to pay any taxes when withdrawing the earnings.

However, if it’s going to be 5+ years before you will need to withdraw your money and you’re in a high tax bracket now and expect to be in a lower one in retirement, then you should probably keep your money in a 401(k) so you can take advantage of the tax deduction.

The Difference in Tax Rates Between Your Current Income Bracket and the One You Expect When You Retire

If your tax bracket will be the same or higher in retirement, then a Roth IRA might be a good option because withdrawals are not taxed.

On the other hand, if it will be lower, you should choose a 401(k) because contributions come from pre-tax dollars, and only up to $17,500 (or $23,000 if age 50+) can be contributed to a Roth IRA.

Whether or Not You Want to Withdraw Roth IRA Contributions or Earnings

The most important factor in your decision should be how much money you are able to contribute to each account because this will determine how soon you can retire.

Since the limit for Roth IRA is lower than that for a 401(k), if you have the choice of contributing to one or the other, it is usually better to contribute to a Roth IRA because you will not get an immediate tax break and your money can grow without paying taxes.

Whether or Not Your Employer Offers Matching Contributions

If your employer does offer matching contributions, then you should strongly consider choosing a 401(k) because it is free money and you will miss out on that if you choose the Roth IRA.

Which Investments Are Available to You

If one type of investment is not offered by your employer and is available through the other, then the better option for you would be to contribute to the account that offers that investment.

Whether or Not Your Income Makes You Eligible for a Deductible IRA

Even though Roth IRA has a lower contribution limit than the deductible IRA if you are in a higher tax bracket now compared to what you expect your retirement tax bracket to be, then go with Roth IRA because withdrawals will be tax-free. If it’s vice versa, then a deductible IRA might be the better option for you.

How Much Do You Value the Safety of Your Investments Over Their Return

If you are risk-averse, choose a Roth IRA because it offers more safety than a 401(k).

How Soon Do You Plan On Retiring

If your goal is to retire earlier, then the Roth IRA might be a better choice for you because it has a lower contribution limit.

On the other hand, if you want to retire later and will need every penny in your retirement fund, then go with a 401(k) because money can grow faster as well as be tax-free.

Now that you know the factors to consider when choosing between a Roth IRA and 401(k), hopefully, it will be easier for you to make an informed decision about which one is right for you.  

The Bottom Line

The Roth IRA and 401(k) are both great options for retirement saving, but you should choose the one that best fits your financial situation. If you have to contribute to only one type of account, then it’s usually better to contribute to a Roth IRA if your income is too high for deductible IRA or if your employer does not offer matching contributions.

However, if both types of accounts are available to you and your employer offers matching contributions, then contribute to the 401(k) because it will receive free money from your employer. While the Roth IRA might be better for diversification purposes or have lower fees associated with it, don’t choose an investment just because it has a lower fee associated with it.

Make sure the investment is available through the account you will be contributing to and that you are choosing between Roth IRA and 401(k) because they offer different investments rather than just lower fees. Also, when possible, contribute to both accounts since this will allow your money to grow without having to pay taxes on it.

Roth IRA is an individual retirement account. It is also known as a post-tax contribution because no taxes are charged on the money you withdraw at retirement, unlike with 401(k) where taxes are deferred until withdrawal.
A 401(k) is another type of individual retirement arrangement that is offered by some employers. 401(k) allows you to defer taxes until withdrawal, while Roth IRA does not have this option because taxes are already deducted at the start of the year.
A Roth IRA has no tax deduction when you contribute your income, while a 401(k) has tax deduction. A 401(k) offers more safety than Roth IRA since you can borrow from it and even take loans from it for purchasing a house, but the downside to this is that there may be penalties associated with 401(k).
Both accounts have different requirements for the amount you must invest and what kind of investment options it offers. Roth IRA lets you invest in almost any investment, while 401(k) only allows certain types of investments such as mutual funds and directly purchasing stocks and bonds. If your employer offers matching contributions, then go with 401(k) because free money is never a bad idea.
Advantages: Low minimum investment required compared to 401(k), no taxes on your contributions or withdrawal, different investments that can be bought, higher contribution limits for people over 50 years old. Disadvantages: You can't borrow from it or take a loan against it if you need to, might have higher fees compared to 401(k), contribution limit is lower than a 401(k).

401(k) Plan | A Complete Beginner's Guide

401(k) Meaning

The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.

Traditional 401(k) vs Roth 401(k)

There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.

Contributing to Your 401(k) Retirement Plan

Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.

Pension vs 401(k)

Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.

How Much Should I Contribute to My 401(k)?

Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.

Plan in Advance

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401(k) Plan FAQs

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.