401k vs Roth IRA: What to Know (2024)

When it comes to retirement accounts, it’s critical to give careful thought to where you put your hard-earned money. While we often consider which investments we choose, it’s less often that we focus on which accounts best serve our financial goals. This article will focus on two of the most well-known retirement accounts as we discuss the differences between traditional 401k vs Roth IRA.

Both of these options are popular tax-advantaged retirement savings accounts. In layman’s English, they are long-term savings accounts with restrictions on taxation, investment, and withdrawals. The purpose is to make it easy to invest in your future by holding your money in a stable portfolio. Furthermore, the high penalties for early withdrawals serve as an added incentive to leave your funds so they can grow.

Let’s start with a quick rundown of each.

Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. Any securities named in this article are for informational purposes only and do not constitute investment advice. It’s up to each investor to do their due diligence when dabbling in the stock market. Always consider your personal situation – and the help of a licensed financial professional – when making any investment decisions.

If you don’t have a licensed financial professional handling your investments, we can help! Check out Financial Professional’s investment marketplace, where we partner with some of the best in the business to help you find the right advisor for your needs.

What is a 401k?

A 401k is an employer-sponsored retirement account named after Internal Revenue Code, section 401(k). (While Roth 401(k)s do exist, this article will focus on traditional 401(k)s, which are far more common.)

Contributions and Limits

In a traditional 401k, employees make contributions into their accounts on a pre-tax basis. The money in the account comes from your gross income, rather than your net (post-tax) income.

Many employers provide a matching contribution (up to a limit) based on a percentage of the employee’s income. For instance, the most common employer match is 50 cents for every dollar you contribute (50%). This perk is available for up to 6% of your total annual salary.

Keep in mind that there are limits for 401k contributions. While the employer match doesn’t count toward your limits, the matched amount does count toward the yearly allowable total cap. In 2020, this combined contribution limit is set at $57,000 for under-50s and $63,500 for over-50s.

Over the years, your funds will grow (hopefully). Eventually, you will pay ordinary income tax on withdrawals on the back end.

Withdrawals and Required Minimum Distributions

It’s important to remember that you have to wait until 59 years, or 6 months of age before you can withdraw funds without the 10% penalty. (This applies to all retirement accounts minus 457(b)s.)

However, if you’re an individual who continues working beyond the retirement age, there’s another factor to consider. On 1 April following your 72nd birthday or retirement, whichever comes second, you must take the required minimum distributions (RMDs).

Depending on your plan provider, the investment options available to you may vary wildly. The important point with a traditional 401k is that regardless of the fund(s) you select, all returns will be tax-deferred.

Traditional 401(k)s at a glance

  • Employer-sponsored, tax-deferred account
  • Combined contribution limit of $57,000 under 50 years old; $63,500 over 50 years old
  • 10% penalties on withdrawals before 59 years, 6 months of age
  • Required minimum distributions start 1 April the year after you retire or turn 72
  • Investment options vary widely and are limited to provider offerings

What is a Roth IRA?

The main distinction between a traditional 401k vs a Roth IRA is in the definition. Roth IRA stands for Individual Retirement Account. A Roth IRA is a contract between a financial institution, such as a bank or a broker, and an individual. This allows you to customize your investment choices to your preferences, as there is no plan provider to dictate options.

Eligibility

It’s important to note that, unlike a 401k, not everyone is eligible to make contributions to a Roth IRA. Eligibility is dependent upon your adjustable gross income. This means that if you make above a certain annual income, you will be “phased out” from Roth IRA contributions. Additionally, if you are eligible to contribute, there is still a maximum amount you can invest in a given year. This maximum contribution is based on your adjustable gross income. You can find this information here on the IRS website.

Contributions and Taxation

The primary difference between how Roth IRAs and traditional 401(k)s function lies in the tax rules. Unlike traditional retirement accounts, where you make contributions pre-tax, you can include Roth contributions in your income the year you contribute. Additionally, any gains on your investments will not be taxed while your funds remain in the account.

Due to the taxes on the original contribution, taxation on withdrawals is different as well. Assuming that you make qualified withdrawals from your Roth IRA, your funds come out tax-free. However, unlike your 401k, there are a few ways to avoid taxes and penalties on early withdrawals, such as:

  • Taking withdrawals due to a permanent disability
  • A beneficiary makes a withdrawal after your death
  • You make a withdrawal and use the funds to buy, build, or rebuild your first home

There are other circ*mstances to avoid the penalties (but not the tax), but we won’t cover them in this article.

Another important tidbit to know is that you are never required to take a minimum distribution from your Roth IRA. If you choose not to touch this account during your retirement, the funds can continue to grow until your beneficiaries inherit your estate.

Roth IRAs at a glance

  • Individually sponsored, post-tax account
  • Annual contribution limit of $6,000
  • Penalties and taxes applied on withdrawals before 59 years, 6 months of age
  • Exceptions made for special circ*mstances, such as permanent disability
  • No required minimum distributions, ever
  • Only your preferences limit your investment options

401k Vs Roth IRA: Which is Better for You?

For most people, it’s wise to choose a Roth IRA vs a 401k. This is due to their increased flexibility and taxation at current income rates. (In other words, your money is taxed within the income bracket in which it was earned). Nevertheless, if you don’t qualify to contribute to a Roth IRA, you likely won’t be able to find a better alternative than a traditional 401k on your own.

However, if you are eligible for both a Roth IRA and a traditional 401k, it’s time to ask the question. Which investment option makes the most sense for you?

The answer, quite simply, is both. Diversification – in which you invest in multiple types of opportunities – is incredibly important in building a robust portfolio.

Diversifying Your Retirement Portfolio

Under the current tax code, it is permissible to contribute to both types of retirement accounts in the same tax year. However, you must still adhere to the maximum contribution amounts on both accounts. In 2020, the max 401k contribution sits at $19,500 if you are under 50 years old. The maximum IRA contribution currently sits at $6,000.

Diversification is a common term in the investment world. Unfortunately, few people consider the importance of diversification across tax-status withdrawals from investment accounts. If you have the opportunity to diversify your retirement accounts, take a hard look at your financial future. For most individuals, the benefits are quickly clear.

Even if you’re unable to max out either account, it may be worth considering paying into the two simultaneously, as you can use the traditional 401k payments to lower your adjusted gross income. Let’s break this down.

401k contributions are calculated pre-tax. This means that the government does not consider these funds in your gross income, thereby deducting the contribution from your total income.

In some cases, your contributions may be enough to lower your adjusted gross income into a Roth IRA-eligible bracket. This allows you to simultaneously contribute to the tax-free retirement income sleeve of your portfolio.

Diversification of your retirement accounts makes the most sense if you’re either:

  • Currently slotted in a low-income tax bracket
  • Expecting to reside in a higher tax bracket come your retirement

How to Use Both a Roth IRA and 401k To Your Benefit

When the time comes to finally spend your hard-earned monies during retirement, ideally, you should deplete the traditional 401k assets first. This gives your Roth assets more time to accumulate interest. You should dip into your Roth assets only once you have emptied your traditional 401k account. This approach allows you to maximize your tax-free income potential during retirement.

At the end of the day, you should make financial decisions that make sense for your future. The choices you make about your retirement accounts affect not only you, but your spouse, children, and other loved ones. When you pass, your estate will continue to benefit those named with the resources you spent a lifetime accumulating.

To make it short and sweet: if your employer offers a 401k-matching program, you have an excellent opportunity to save money – tax-free – at your fingertips. While a Roth IRA doesn’t offer the same benefits as other accounts, it may make sense for different income brackets. However, the idea is to diversify and expand your retirement investment portfolio as far as possible. This means that those who can take advantage of both options should in order to secure a well-funded retirement.

Financial Professional would like to remind you that you should always consult a tax professional before making any tax-related decisions. On the other hand, don’t underestimate the power of making wise decisions with the free tools at your disposal.

401k vs Roth IRA: What to Know (2024)

FAQs

401k vs Roth IRA: What to Know? ›

Key Takeaways

How to choose between 401k and Roth IRA? ›

Roth 401(k) is best for you. Both accounts are easy to set up, but your employer does most of the setting up with a Roth 401(k), whereas you'll need to do the work yourself with a Roth IRA (some employers do offer paycheck deductions for IRAs). Want access to a large variety of investments. Roth IRA is best for you.

Is it better to max out 401k or Roth IRA first? ›

If you don't have enough money to max out contributions to both accounts, experts recommend maxing out the Roth 401(k) first to receive the benefit of a full employer match.

What percentage should I put in 401k or Roth IRA? ›

Most financial planning studies suggest that the ideal contribution percentage to save for retirement is between 15% and 20% of gross income.

Why are you are generally better off with a Roth IRA 401k than a traditional IRA 401k? ›

Roth IRAs do not have required minimum distributions (RMDs), meaning you can continue to benefit from tax-free potential growth throughout retirement without having to take money out. RMDs in 401(k)s and traditional IRAs require distributions beginning at age 73.

Should I roll over my 401k or put it into a Roth IRA? ›

If you're transitioning to a new job or heading into retirement, rolling over your 401(k) to a Roth IRA can help you continue to save for retirement while letting any earnings grow tax-free. You can roll Roth 401(k) contributions and earnings directly into a Roth IRA tax-free.

Should I split my 401k contribution between Roth and traditional? ›

Should You Split Contributions Between a Roth and Traditional Account? Splitting contributions between a Roth and traditional account can allow you to get some tax benefit today while hedging somewhat against higher tax rates in the future.

Should high income earners have 401k or Roth 401k? ›

Tax diversification: High-income earners often find themselves in higher tax brackets. A Roth 401(k) account gives you more flexibility in managing your tax liability during retirement. Having a Roth account also allows you to be strategic about the tax treatment of your investment choices.

What is a major advantage of the Roth over a 401k? ›

The biggest benefit of the Roth 401(k) is this: Because you already paid taxes on your contributions, the withdrawals you make in retirement are tax-free. That's right! The money you put in—and its growth! —is all yours.

Is a 401k worth it anymore? ›

The value of 401(k) plans is based on the concept of dollar-cost averaging, but that's not always a reliable theory. Many 401(k) plans are expensive because of high administrative and record-keeping costs. Nonetheless, 401(k) plans are ultimately worth it for most people, depending on your retirement goals.

How much should I have in my 401k at 55? ›

By age 40, you should have three times your annual salary already saved. By age 50, you should have six times your salary in an account. By age 60, you should have eight times your salary working for you. By age 67, your total savings total goal is 10 times the amount of your current annual salary.

How much of my paycheck should go to my 401k? ›

Many companies offer 401(k) plans to encourage employees to save for retirement. Some even match contributions you make yourself. Aim to save at least 15% of your pretax income each year for retirement (including employer contributions). This can be in a 401(k) or another retirement account.

How much money do you need to retire with $100,000 a year income? ›

More? Financial planners often recommend replacing about 80% of your pre-retirement income to sustain the same lifestyle after you retire. This means that if you earn $100,000 per year, you'd aim for at least $80,000 of income (in today's dollars) in retirement.

Why 401k is better than Roth IRA? ›

Key Takeaways

Contributions to a 401(k) are tax-deductible and reduce your taxable income before taxes are withheld from your paycheck. There is no tax deduction for contributions to a Roth IRA, but contributions and earnings can be withdrawn tax-free in retirement.

Why is a Roth 401k bad? ›

If you're saving exclusively in a Roth 401(k), your options to access that money are limited before the age of 59 1/2. While you can withdraw any amount you contributed to a Roth 401(k) at any time without taxes or penalties, the earnings typically cannot come out penalty-free before you reach age 59 1/2.

Is it better to pull from 401k or Roth IRA? ›

The money in both accounts grows without being diminished by taxes. You will pay taxes on amounts withdrawn from a 401(k) once you're retired. You pay no taxes on withdrawals from a Roth IRA.

Is 401k match better than Roth IRA? ›

A big advantage that the Roth 401(k) has over the Roth IRA is the possibility of an employer matching your contributions up to a certain percentage. Employer matches are the closest thing there is to “free money,” so if you're deciding between a Roth 401(k) vs. a Roth IRA — keep this in mind.

Should I do pretax or Roth 401k or both? ›

Taxable income and tax bracket

For instance, if you're in a high tax bracket now, and you believe you'll earn less once you reach retirement, then you may wish to consider contributing to a pre-tax account. Roth 401(k) contributions on the other hand do not affect your current taxable income.

Should I do a solo 401k or Roth IRA? ›

While the Roth IRA is more accessible than a Roth solo 401k, it comes with a much lower contribution limit. In fact, a Roth solo 401k has a limit three times larger than a Roth IRA. The contribution limit for a Roth solo 401k is $22,500 ($30,000 if age 50+) for 2023 and $23,000 ($30,500 if age 50+) for 2024.

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