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.
However, if you’re exploring whether you should opt for a 401(k) vs. a Roth IRA, learning about each plan’s features can help you prepare your finances for a more comfortable retirement.
401(k) vs. Roth IRA: 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 draw 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.
|Eligibility||– Available through employer programs only
– Typically a waiting period to enroll
|– Must have earned income
– Restrictions after a certain income, depending on your filing status
|Taxes||– Contributions made with pre-tax dollars
– Taxes paid on money when withdrawn
|– Contributions made with after-tax dollars
– No taxation on qualifying withdrawals
|Contribution Limits||– $22,500 per year for those under 50
– $30,000 per year for 50 and older
– Additional contribution limits for highly compensated employees
|– $6,500 per year for those under 50
– $7,500 for people aged 50 and older
|Employer Contribution||Most employers match contributions based on a percentage of your gross earnings||No employer matches|
|Required Minimum Distributions (RMDs)||At age 73, annual minimum withdrawals are required to avoid penalties||Money can sit in the account for as long as you live|
|Investment Options||Third-party administrators control the account, limiting your investment options||Freedom of choice and management of assets in your investment portfolio|
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 You contribute a percentage or set amount of your pre-tax income and then pay taxes on the money when it’s withdrawn for your retirement.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).
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.
High Contribution Limits
You can contribute up to $22,500 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.
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.
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.
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
When it comes to disadvantages, the Roth IRA has only one. It only allows contributions of up to $6,500 per year or $7,500 if you’re 50 or older, which is significantly lower than the contribution limits of a 401(k).
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.
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.
FAQHere 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.
Lydia Kibet contributed to the reporting for this article.
Information is accurate as of April 28, 2023.
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