Key Takeaways
- Roth IRAs and 401(k)s are tax-advantaged methods to build your savings for retirement. A Roth IRA is an individual savings plan, while a 401(k) is offered through your workplace.
- A 401(k) reduces your total income, which lowers your tax bill while you’re working. Withdrawals are taxed as ordinary income at your income rate in retirement.
- Roth IRA contributions don’t affect your tax rate when you contribute, but withdrawals are tax-free.
- Employers will often match your 401(k) contributions, allowing you to grow your savings faster.
- One option may suit your retirement plan better than the other, but you can also choose both.
401(k)s and Roth IRAs are both tax-advantaged savings plans that can help you build your retirement nest egg. A 401(k) is an employer-sponsored plan that lets you assign part of your paycheck (pre-taxes) for automatic contribution into pre-arranged investments. Many employers incentivize employees to contribute by matching contributions, usually up to 50% of what you contribute.
A Roth IRA is an individual retirement account that you set up yourself at the financial institution of your choice. You decide how much to contribute and when, along with which type of investment to make. Distributions from a Roth IRA are tax free.
Understanding the similarities and differences between these two savings strategies can help you decide where to direct your contributions.
Comparing Roth IRAs and 401(k)s
There are similarities and differences between 401(k)s and Roth IRAs. Both come with tax advantages that apply in different ways. The rules about how much you can contribute each year and how much – and when – you must withdraw are also unique to each type of plan.
Tax Treatments
Your 401(k) contributions are made with pre-tax dollars. Your contributions are deducted from your taxable income, so you pay less income tax as you make them. When you withdraw from your 401(k) in retirement, your withdrawals are taxed as ordinary income. By then, you may pay taxes at a lower rate if your income is lower.
Your contributions to Roth IRAs are made with after-tax dollars. You cannot deduct your contributions from your income. However, because you have already paid income tax on them, you can withdraw your Roth IRA funds completely tax-free in retirement.
Contributions and Distributions
You can contribute to your 401(k) and Roth IRA up to a maximum amount each year. That maximum is set by the IRS and changes regularly. In 2024 you can contribute up to $23,000 to your 401(k). There is also an additional catch-up contribution if you are age 50 or older. In 2024 the catch-up limit is another $7,500; therefore, if you are over 50, you can contribute up to $30,500.
These limits do not include any matching contributions made by your employer, but the IRS also sets a limit on your combined contribution amounts. In 2024 you and your employer together can contribute up to $69,000 to your 401(k), with an additional $7,500 catch up if you are over 50, for a total of $76,500. The IRS also halts combined contributions at 100% of your salary, even if that amount is less than $66,000.
In 2024 you can contribute up to a maximum of $7,000 to your Roth IRA with an additional catch-up limit of $1,000 if you are over 50, for a total of $8,000. Roth IRA contributions are tied to your income. You can only contribute up to the maximum if you earn less than $146,000. If you earn between $146,000 and $161,000, your contributions are reduced. If you earn $161,000 or more as a single filer, head of household or married filing separately, you cannot contribute to a Roth IRA.
If you are married and file your taxes jointly, you can contribute the full amount up to a combined income of less than $230,000. You can contribute reduced amounts if your combined income is $230,000 to $240,000. You cannot contribute if your combined income is $240,000 or more.
Investment Options
A 401(k) plan is set up and sponsored by your employer. Your employer selects the plan provider, and your investment options are usually limited to the choices provided. 401(k) plans generally include investment options like mutual funds and exchange-traded funds (ETFs).
A Roth IRA lets you choose both the provider and the investments. You can choose any type of investment vehicle for your contributions. In addition, you’ll have much more control over the balance and makeup of your account.
Both plans offer tax-advantaged growth. With a 401(k), you are not taxed on any investment gains until you withdraw from it in retirement. At that point, your withdrawals are taxed as ordinary income. Gains in your Roth IRA account are always tax-free, both as it grows and when you withdraw from it.
Required Minimum Distributions (RMDs)
RMDs are the mandatory amount you must withdraw from your retirement accounts each year once you turn 73. You can choose to take your RMDs in lump sums or as monthly withdrawals. The latter option gives you the chance to keep your money growing as long as possible. The administrator of your 401(k) plan is required to inform you of the amount of your RMDs each year.
There are no distribution requirements for the original account holders of Roth IRAs. You do not have to withdraw from your Roth IRA if you choose not to. In fact, you can leave the entire amount of your Roth IRA to your beneficiaries, who will then be subject to RMDs and have 10 years to take them.
Withdrawal Flexibility
Although you must withdraw RMDs after you reach 73, you are allowed to withdraw from your 401(k) or Roth IRA without financial penalty once you turn 59 ½. However, you must have had your Roth IRA for at least five years. If you withdraw before that age, you will be taxed an extra 10% on the amount.
There are penalty-free exceptions made for early withdrawals in cases of disability or serious hardship. This situation is reserved for those with burdens that cause immediate and heavy financial need. To avoid the 10% penalty on early withdrawals, you must provide documentation that proves you need the funds.
Both Roth IRAs and 401(k) plans are excellent tax-advantaged ways to save for your retirement. You can hedge against unknown future tax rates in retirement by making both types of contributions.
Toby Walters, CFA®Senior Financial AnalystToby Walters, CFA®, is a senior financial analyst with over 25 years of experience in financial research. His knowledge spans researching and analyzing financial data to developing a one-of-a-kind viewpoint on money-related topics.
Which Is Right for You?
Depending on your personal needs, you might find either a 401(k) or a Roth IRA fits more easily into your personal budget or situation. There is no “correct” answer when choosing, only certain factors to consider before deciding which option is best for you.
Which Option Best Suits You?
Depending on your employment, income and personal preferences, you might find that one type of savings plan better suits your needs than the other.
When Should You Choose a Roth IRA or a 401(k)?
| Roth IRA | 401(k) |
|---|---|
| If you prefer complete control over your investments | If you prefer a hands-off approach to investing |
| If you are self-employed | If your employer will match your contributions |
| If you earn less than $146,000 | If you want to make larger annual contributions |
| If you have already maxed out your 401(k) contributions | If you have already maxed out your Roth IRA contributions |
| If you can comfortably pay all your taxes as you contribute | If you want to reduce the amount of taxes you pay while you contribute |
Financial Benefits
It’s important to consult a trusted financial advisor when deciding on your 401(k) or Roth IRA contributions. Your advisor can help you understand the tax implications of your choice, as well as outline contribution limits and RMDs.
- Employer Matching
- If your employer matches your 401(k) contributions, you can grow your retirement savings more quickly.
- Tax Considerations
- Do you want to pay taxes now or in the future? Your advisor can help you determine which will offer the most benefit when you retire.
- Contribution Limits and Savings Goals
- Consider the amount you can contribute and how much you want to save. A 401(k) or Roth IRA may be better for you based on your ultimate goals.
- Investment Options and Flexibility
- How important are investment control and flexibility to you? If you want a hands-off approach to your retirement savings, a 401(k) may suit you better than a Roth IRA. Conversely, if you want to target specific investments, consider a Roth IRA.
- Required Minimum Distribution (RMD)
- Understand how RMDs will affect your income in the future.
- Early Withdrawals
- Both plans have the same penalties for early withdrawal, except in cases of extreme financial hardship or disability.
Things To Consider
Have You Considered Having Both Simultaneously?
You are not limited to either a 401(k) or a Roth IRA; you can choose to invest in both. An employer-matching 401(k) boosts your retirement savings with no extra effort on your part, leaving you the freedom to also invest in a Roth IRA. And while a 401(k) offers you immediate tax benefits, a Roth IRA promises significant tax benefits in the future, as well as more control over your investment choices.
Another advantage of having both types is that it’s not known what the tax rates will be when you’re retired. You can hedge and have a type of tax diversification by having some of your retirement savings withdrawals as tax-free and some as taxable.
Your own financial situation, investment goals, contribution limits and eligibility requirements will help you decide which type is right for you. Remember, a financial advisor can explain how either type – or both – can help you reach your financial goals and live the life you want in retirement.
Read More: Roth IRA Calculator
Editor Malori Malone contributed to this article.
