Roth IRA vs. 401(k): Which Should You Choose?

The Roth IRA and 401(k) are two of the most popular retirement accounts. Choosing which strategy is best for your circumstance can be a tough decision. This article will compare the benefits of choosing a Roth IRA vs. 401(k) and help you decide where to save and invest for the long run.

What Are the Differences Between Investing in a Roth IRA vs. 401(k)?

The first significant difference between investing in a Roth IRA versus a 401(k) plan is how you go about making contributions. With a Roth IRA, the onus is on you to open the account (usually at a popular online brokerage company’s website) and then fund it. The contribution often comes from your checking or savings account, and it must be done with cash.

With a 401(k), contributions come directly from your paycheck through your employer’s payroll system. New employees usually elect 401(k) plan contributions to complete benefit enrollments. Investment choices are fewer in a 401(k) plan, but there will generally be a set of both stock and bond funds from which to choose. Many plans now offer a set of target-date mutual funds, too.

The second significant difference between a Roth IRA and 401(k) is the tax treatment. Roth contributions are made after-tax, while regular 401(k) deferrals are done pre-tax. That means you pay income tax today when putting money into a Roth IRA, while you get a current-year tax deduction when making 401(k) contributions.

Snatch the 401(k) Match

It’s also important to consider how employer matching contributions work within a 401(k) plan. Many firms have a matching policy; for example, 50% of the first 6% of contributions. That means, if you earn $100,000 and contribute $6,000 per year into your 401(k), your employer will pop in another $3,000 at no cost to you. That is an instant 50% return on your money in that scenario! It’s a great deal. Employer contributions are made pre-tax, regardless of whether you elect regular pre-tax contributions or Roth. Of course, there is no employer match with a Roth IRA.

Early Withdrawal Rules

Here is a situation where a Roth IRA beats out the Roth 401(k): early withdrawals. Usually, pulling money out of your retirement comes with a penalty. That is not always the case with a Roth IRA since you can withdraw contributions at any time. The IRS also allows you to take out earnings from a Roth IRA penalty-free in some situations. Some of the more common reasons to take the earnings out of a Roth IRA early include money for a first-time home purchase, qualified education expenses, qualified medical expenses, and for disability or death. You can view the IRS list of all the reasons here.

Beyond Traditional 401(k)s, How Do Roth IRAs Differ From Roth 401(k)s?

Another trend that has emerged in the 401(k) space is the offering of a “Roth” 401(k). A Roth 401(k) works like a Roth IRA in some ways and like a 401(k) in other ways. We know that “Roth” means contributions are made after-tax. A Roth 401(k) is simply another employer-sponsored retirement account, but money in that account has already been taxed and will grow tax-free through retirement.

Roth IRAs Offer Withdrawal Flexibility vs. A Roth 401(k)

A Roth IRA differs from a Roth 401(k) in that contributions made to a Roth IRA can be withdrawn tax-free and penalty-free at any time. Inside a Roth 401(k), the plan participant faces a 10% early withdrawal penalty on withdrawals made before age 59½.

Annual Contribution Limits

A Roth IRA also has a lower annual contribution limit than a Roth 401(k). According to the IRS, the maximum IRA contribution for 2021 and 2022 is $6,000 ($7,000 for those age 50 or older). The most you can put into a 401(k) plan is $19,500 in 2021 ($26,000 for those age 50 or older) and $20,500 in 2022 ($27,000 for those age 50 or older). Those limits apply to combinations of Traditional IRA and Roth IRA contributions and Regular and Roth 401(k) contributions, respectively.

Beware of Roth IRA Income Limits

You will not be able to contribute to a Roth IRA if your income exceeds certain thresholds. A Roth 401(k) does not have an income limit. For Roth IRAs, retirement savers should review rules determined by the IRS. High-income individuals and couples should forecast their adjusted gross income for the year before making Roth IRA contributions.

Roth 401(k), Roth IRA, and Pre-tax 401(k) Retirement Accounts (IRS)

Source (table): https://www.irs.gov/retirement-plans/roth-comparison-chart

Required Minimum Distribution Rules

Required Minimum Distributions (RMDs) are something to be mindful of with 401(k) plans. Your RMD is the minimum amount you must withdraw from your retirement account each year. The IRS does not allow retirees to leave money in a tax-sheltered vehicle. They want a cut of your nest egg! Retirement savers generally have to begin taking Traditional IRA and regular 401(k) withdrawals at age 70½. The SECURE Act changed the RMD beginning age, pushing back mandatory distributions until age 72 for those turning 70 on July 1, 2019, or later.

A Roth 401(k) is subject to the plan’s RMD rules, so be sure to know your plan’s details. The best news is Roth IRA money is not subject to RMD rules. Moreover, retirees can roll over their Roth 401(k) to a Roth IRA to bypass required withdrawals.

When Should You Choose One vs. the Other (or a Mix of Both)?

Your situation is paramount when deciding on retirement saving strategies (like most aspects of long-term financial planning). However, it is wise to ensure you get the most out of these tax-advantaged accounts. Snatching the company 401(k) match is usually a good first move. Many millennial and Gen Z savers should investigate their plan vesting policies. If a company requires a worker to remain with the firm for five years before the match is vested, putting your first savings dollar into the plan might not make sense. Nevertheless, contributing to a 401(k) up to the match is often a good first step toward saving for retirement.

Contribute to the 401(k) Plan Match, Then Go for the Roth IRA

After getting the match, focusing on putting the maximum to a Roth IRA can be a savvy move. Roth IRAs are more flexible than 401(k) plans since you can withdraw your contributions at any time tax-free and penalty-free. With more investing options—often at a lower cost—you can keep more of what’s yours in an IRA versus a 401(k).

“Once an individual is saving enough in their 401(k) to take advantage of the full company match, it usually makes sense to then save additional dollars to a Roth IRA (if their income allows this),” says Eric Simonson, financial planner and founder of Abundo Wealth. “The benefits of a Roth IRA over a 401(k) are: 1) You are the owner of the account, rather than a plan participant. 2) You have far greater investment options to add diversification and potentially lower your fees. And 3) Roth IRAs have more favorable withdrawal options, and these dollars are potentially more accessible than a 401(k).”

Use Online Resources to Help You Choose How to Save for Retirement

So, a mix of 401(k) and Roth IRA contributions makes sense for many people. Workers in their high-earning years are likely to be better off making pre-tax contributions (e.g., Traditional IRA contributions and regular 401(k) deferrals). In contrast, younger workers in their low-earning years might be better suited to choosing after-tax Roth contributions. Here is a tip: Be sure to research online calculators to help determine which contribution type and account type are ideal for your situation.

How Should a Super-Saver Make Retirement Contributions?

Super-savers can contribute to both a Roth IRA and 401(k). In 2022, a worker under age 50 could hypothetically put $6,000 into a Roth IRA and $20,500 into a 401(k). The $6,000 IRA limit can be comprised of both Roth and Traditional IRA contributions. The same logic applies to 401(k) contributions—a plan participant’s $20,500 payroll deduction can be a mix of pre-tax and Roth money.

Knowing Thyself & Retirement Saving Strategies

Always be sure to review your financial situation as the years go by, or hire a financial advisor such as a Certified Financial Planner who can work with you to understand your unique circumstances. The cost of hiring a financial advisor may be less than you think, as an increasing number of advisors offer subscription-based pricing or will charge a flat fee to build your personalized financial plan.

Knowing your marginal income tax rate is essential, as is the level of your emergency savings. Having a solid grasp of your hierarchy of saving priorities helps you optimize building long-term wealth.

Ask yourself: Are you a saver or spender? People who have a challenging time saving should consider making Roth contributions. With Roth IRA and Roth 401(k) contributions, retirement savings are made after-tax, so taxpayers do not get a bigger tax refund. Spendthrift individuals will not be tempted to spend the tax savings immediately. If you are a diligent saver, making pre-tax contributions and simply investing the current-year tax savings in a taxable account could make more sense.

The Better Move Might Come Down to Taxes

Here’s an example: Suppose $5,000 of retirement savings went into a Roth IRA, and the individual has a 22% marginal tax rate. You essentially pay $1,100 of income tax in the current year, but your account grows tax-free forever. With a pre-tax account, that $1,100 will show up in your tax refund the following spring when you file. Natural spenders might be tempted to make a big purchase with the tax savings. Meanwhile, that $5,500 is subject to income tax upon withdrawal during retirement.

Special Circumstances for Foreign-Born Families

Depending upon your status as a US citizen, it’s essential to consider additional factors that could have a meaningful impact on your potential tax advantages of choosing a Roth IRA vs. 401(k). A financial advisor who specializes in working with immigrants and foreign nationals could prove invaluable to minimizing the risk of losing tax benefits.

“With the foreign-born families that I work with, there is always a possibility that they plan to go back to the country where they were born. In this case, then we consider whether the foreign country will recognize the tax-free nature of the Roth IRA,” says Jane Mepham, financial planner and founder of Elgon Financial Advisors. “Some countries like Germany do not and will tax the Roth IRA account again at withdrawal. In that case, I would shy away from having the client open a Roth IRA and have them stick with the 401(k) account.”

The Takeaway and Call to Action

Consider your current tax rate versus your tax rate in retirement when deciding on pre-tax or Roth contributions. If you are in a relatively high tax bracket today, pre-tax contributions might be the better play. Also, weigh the flexibility of a Roth IRA versus sometimes-stringent 401(k) plan rules. If you might need to pull money out of your retirement accounts, a Roth IRA is a better option. Of course, knowing your 401(k) plan’s employer matching rules is essential to getting the most bang for your retirement savings buck.