When it comes to saving for retirement, you have a ton of options to choose from. Do you open a traditional IRA or a open a Roth IRA? Both can help you save for retirement, but while a 401(k) is a tax-deferred plan offered through a workplace, a Roth IRA is an individual plan where you pay taxes on money before it goes in. A good place to start is simply to familiarize yourself with the retirement options that you have. For more help with retirement planning and other financial issues, consider working with a financial advisor.
Roth IRA Definition
A Roth IRA is an individual retirement account (IRA) that you set up with a financial institution, like a bank or investment firm. You fund Roth IRAs with your after-tax money, which means you can’t deduct your contributions at tax time. However, when it comes time to withdraw your savings during retirement, that income isn’t taxable.
A Roth IRA differs from a traditional IRA which you fund with pre-tax money. You then pay regular income taxes on your traditional IRA withdrawals during retirement.
401(k) Definition
You may be more familiar with 401(k) plans. These are the plans that employers sponsor, meaning you don’t have to open and fund one by yourself. You contribute to a 401(k) by designating a portion of each paycheck to go toward your plan. Since you fund a 401(k) with pre-tax income, you pay taxes on that money when you make withdrawals during retirement.
It’s important to note that 401(k) plans can also come with an employer match program. Employers can choose to match an employee’s contribution, often up to a certain percentage of the employee’s income. The exact terms of the match will depend on each employer. A common example of this match program includes an employer matching 50% of an employee’s contribution, up to 6% of the employee’s salary. Luckily, your employer match does not count toward your 401(k) limit.
Roth IRA vs 401(k)
On the surface, Roth IRAs and 401(k)s don’t have too much in common except offering a tax-advantaged way to save for retirement.
Since a 401(k) is employer-sponsored, you don’t have to be as hands-on with managing the account as with an IRA. But since you can have both a Roth IRA and a 401(k), it can help to note their differences and similarities. That way you can optimize each account and your savings.
Eligibility & Contribution Limits
Your eligibility for a 401(k) plan simply depends on whether your employer offers one. Generally, you have to inquire a little bit more about taking advantage of an employer match program.
On the other hand, without an employer’s help, a Roth IRA may not prove available to everyone. For one, you have to find an institution with which to open your account. Some institutions may only accept applicants with high deposit amounts, limiting their products to more wealthy clients.
It’s important to note, however, that Roth IRAs offer a solid savings option for those with lower income. This is because you fund a Roth IRA with after-tax money, making your withdrawals tax-free. This structure comes in handy for people who see themselves in a higher tax bracket in retirement.
Plus, Roth IRA rules and limitations tend to phase out higher earners. For tax year 2024, total contributions to Roth (and traditional) IRAs cannot exceed $7,000, or $8,000 for those 50 and older. Those numbers were $6,500 and $7,500 respectively, in 2023.
401(k) plans, on the other hand, have much higher contribution limits.
For tax year 2024, you can contribute up to $23,000 (or $30,500 for those 50 and older) to your 401(k). For tax year 2023, the limit was $22,500 and $30,000. Don’t forget that if your employer matches your 401(k) contribution, their match does not count towards that limit. Instead, you have to ensure your total annual 401(k) contributions do not exceed the lesser of 100% of your salary or $69,000 ($76,500 for those 50 and old) in 2024.
401(k) vs. Roth IRA: Tax Treatment & Distributions
A big difference between Roth IRAs and 401(k)s lies in their tax treatment. You fund Roth IRAs with after-tax income, meaning your withdrawals are not taxable retirement income. Conversely, you fund 401(k)s with pre-tax income. This makes your 401(k) withdrawals subject to taxation in retirement.
When it comes time to make withdrawals in retirement, or distributions, you must start taking required minimum distributions (RMDs) from your 401(k) starting at age 73. RMDs allow the IRS to start taxing those funds. But since a Roth IRA holds after-tax funds, the IRS doesn’t need to tax it again. Therefore, you don’t need to take RMDs from a Roth IRA.
Plus, if you’re under the age of 59.5 and you’ve had a Roth IRA for at least five years, you can withdraw your contributions at any time. The same does not apply to 401(k) plans, however, where you face a 10% penalty on withdrawals before you reach age 59.5. You also still have to pay income tax on early withdrawals, which can severely hurt your savings.
Investment Options
Finally, Roth IRAs and 401(k)s differ in their investment options. With a 401(k), you are limited to the investment options your employer has chosen. The size of the pool you can choose from will depend on your employer, but generally, you cannot choose any investment you fancy.
A Roth IRA provides more control over your investment accounts. Since you (or a robo-advisor) manage the account, you get to choose the asset allocation of your account. That may give you more space to choose low-cost mutual funds and ETFs instead of possibly paying high fees for your employer’s choices.
| Roth IRA | 401(k) | |
| Eligibility | Tends to favor people in lower tax brackets | Depends on whether the employer offers one |
| Contribution Limits |
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| Tax Treatment |
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| Distributions (Withdrawals) |
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| Investment Options |
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| Employer Match? | No | Yes |
Bottom Line
Now that you know more about Roth IRAs vs. 401(k) plans, you can better make decisions regarding your retirement savings. Plus, the differences between these plans make them ideal partner accounts. You can have a 401(k) through your employer and a Roth IRA with a financial institution of your choosing, provided they offer Roth accounts. Then in retirement, you’ll have both taxable and nontaxable income to withdraw.
Tips on Getting Ready for Retirement
- The most important part about saving for retirement is that it’s never too early to start! True, retirement may not be on many 20-somethings’ minds, but the earlier you start saving, the more money you can have in retirement.
- Once you’ve started saving for retirement, try not to compare yourself to your neighbors wondering if your savings are normal. It’s more important to tailor your savings plans to your own current financial situation and your retirement goals.
- Retirement planning can be complex and overwhelming, but a financial advisor can help demystify the process. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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