The 401(k) vs. Roth IRA is a common comparison as it pertains to two of the most common tax-advantaged accounts available to US investors.
Like with many things with competing trade-offs, there’s no one right answer. The 401(k) and Roth IRA each have pros and cons.
So it’s best to consider one’s individual circumstances and the characteristics and rules pertaining to each account in determining how to allocate between the two options.
Because of the differences between various accounts (e.g., 401(k), Roth IRA, self-directed non-tax-deferred), selecting carefully can mean the difference of a lot of money earned/saved at retirement, potentially tens or evens hundreds of thousands of dollars.
Let’s look at each individually.
The Traditional 401(k)
The 401(k) is typically an employer-sponsored retirement account where you contribute money before taxes. This means you won’t pay any taxes on the money you invest in this account.
Because you don’t have to pay taxes on the funds you contribute to the account, you have even more money left over to invest instead of paying it to the IRS.
That allows the extra money you saved in taxes to make you even more money.
Pros of a Traditional 401(k)
Since you contribute pre-tax money, it can be thought of as a convenient tax deduction.
You can contribute up to $19,500 per year in a 401k as of 2022, if under the age of 50 and up to $26,000 per year for those 50 and older.
That’s more than three times higher than what you can contribute to a Roth IRA.
Moreover, some employers offer a 401(k) employer match. That means the company can actually match your contribution, dollar for dollar up to a certain amount. That’s essentially free money for those who take it.
Your employer might even auto-enroll you in the 401(k).
Downsides to the traditional 401(k)
You’ll end up paying taxes on your money when you begin withdrawing it from your account after the age of 59.5.
With a 401(k), you’re basically saving money on taxes now so you have more to invest upfront.
On top of that, if you want to withdraw the money prior to the age of 59.5 for anything other than financial hardship, you’ll be subject to paying a 10 percent penalty on your money and you’ll owe taxes. This money will be considered ordinary income.
You’ll also be forced to begin withdrawing your money at the age of 70.5. So for those who prefer to continue saving and investing in it and letting it continue to grow… unfortunately, you can’t.
Investment options may also be pretty limited, and most don’t really know what to invest in (or have the interest in doing so).
Some smaller companies’ 401(k) fees are also quite high.
The Roth IRA has some similarities to a 401(k) but also many differences.
Pros of a Roth IRA
All of the profit generated in this account is tax-free after the age of 59.5, unlike the 401(k). This means you can take withdrawals without having to worry about paying taxes or bumping yourself into a higher tax bracket.
That could save you a lot of money by the time you retire, especially if you begin investing in this early on.
There are also no minimum distributions. A traditional IRA forces you to begin withdrawing at age 72.
You can also withdraw your Roth contributions – not your earnings generated from the investments in the account – at any time without penalty. So, it can serve as an emergency fund in a pinch.
Downsides of the Roth IRA
With a Roth IRA, you contribute post-tax money. This means the money that’s left over after you’ve already paid taxes on it.
As we all know, the money you have left over after taxes is a lot smaller than before the taxes were taken away.
This means you’ll have less of your money to invest upfront, all things considered.
On top of that, the contribution limits are low. For a Roth IRA it’s capped at $6,000 for those under 50 and $7,000 for those 50 and over. That’s not much, since you’re going to need to contribute more per year to successfully retire.
If you want to contribute more than this, you unfortunately can’t. You have to contribute to a different account.
You also have to set this account up by yourself and remember to fund it each year. Like much of the saving and investing process, it has to become a habit.
There are also income limits to a Roth IRA.
For those whose modified adjusted gross income (MAGI) is around $140,000 or more, no contribution is allowed, and begins tapering from the maximum ($6,000 or $7,000, depending on age) beginning at around $125,000.
401(k) vs. Roth IRA: Final Word
There are trade-offs between the two. So, the “right” mix is probably having both.
While a 401(k) enables you to contribute more and contribute pre-tax money, the disadvantage is having to pay taxes after withdrawing it and having to pay a penalty if you decide to withdraw early (i.e., before the age of 59.5). (In a crisis situation, the US government often waives the penalty.)
If you’re worried about future tax rates, the 401(k) gives more uncertainty given tax rates can change a lot between contribution and distribution. The Roth IRA has an advantage in this respect since you know distributions will be tax-free.
You can also use the Roth IRA as a backup fund. But the money you can contribute per year is low. So the 401(k) has the clear advantage in terms of contribution limits.
Many individuals, if they’re employed at a company, will take their 401(k) and max it out if their employer offers a matching program up to a certain percentage of the contributions. Then they will choose to max out their Roth IRA.
Between the two accounts, if an individual is below the age of 50 and in a position where they can save more than $25,500 ($6,000 Roth IRA plus $19,500 401(k)) – or $33,500 ($7,000 Roth IRA plus $26,500 401(k)) if over the age of 50 – many will choose to max out both to take advantage of all the tax savings they can.
Beyond that, they can move into self-directed brokerage accounts.
Some may choose to use self-directed accounts even before they max out their tax-advantaged accounts to have more freedom in the approach they can take with respect to their investments.