Roth IRA vs. 401(k): which is the better choice for you?

By: Team Stash

Published: Jul 01, 2024

• Updated: Aug 27, 2024

In this article:

1. What is a Roth IRA?
2. What is a 401(k)?
3. Roth IRA vs. 401(k): how do they compare?
4. Factors to consider when choosing between a Roth IRA and 401(k)
5. Roth IRA vs. 401(k): which is right for you?
6. Roth IRA and 401K FAQ

With many types of retirement accounts available, choosing the right one for your financial future can be overwhelming. Roth IRAs and 401(k)s are two popular options; both provide tax advantages and can help you grow your investments over the long term.

What is a Roth IRA?

A Roth Individual Retirement Account (IRA) is a tax-advantaged retirement account in which contributions are made with after-tax income; you put money into the account after you have paid income tax on it. Roth IRAs are subject to income eligibility rules and contribution limits set by the IRS, which are similar to those for traditional IRAs and may change from year to year. The key benefit of a Roth IRA is that qualified withdrawals in retirement are tax-free, for both the contributions you make and the money you earn on those contributions while they are invested in the account.

Eligibility requirements

To contribute to a Roth IRA, you have to meet certain requirements when it comes to your earned income and Modified Adjusted Gross Income (MAGI). To qualify, you must earn income, such as wages, salaries, or self-employment income, and your MAGI must fall within specific limits, which depend on your tax filing status. If your income exceeds the upper limit for your filing status, you may be unable to contribute, or limited to a lower amount.

Contribution limits and deadlines

For the 2024 tax year, total contributions for Roth IRA accounts are capped at $7,000, and you must make contributions by April 15, 2025. If you’re 50 or older, you can make an additional catch-up contribution of $1,000, bringing your total contributions to $8,000.

This limit differs depending on your income and tax filing status. For instance, Roth IRA contribution limits are lower for single filers making $146,000 or more and people who are married, filing jointly who make $230,000 or more. And if your income is lower than the contribution limit, you cannot contribute more than your MAGI for the year.

Tax implications

Tax advantages are a primary appeal of a Roth IRA, and it’s important to understand how they work to ensure you benefit from them.

• Contributions: Contributions are made to a Roth IRA with after-tax income. Because you have already paid taxes on this money before depositing it into the account, you can withdraw it at any time with no penalties, and you will owe no taxes.

• Earnings: Money generated by the investments in your Roth IRA is tax-exempt as long as you follow the withdrawal rules.

• Withdrawals: Withdrawals of your earnings are tax-free once you reach the age of 59½, as long as the account is at least five years old.

If you withdraw your earnings before you’re 59½, you’ll have to pay income tax on the money, plus an additional 10% early-distribution tax. There are a few exceptions to the early-distribution tax, like withdrawing money for education expenses or buying your first home. But even in these cases, you’ll owe income tax on earnings if you withdraw them early.

Investment options and flexibility

With a Roth IRA, you can invest in a wide range of assets. In addition to the typical options like stocks, bonds, mutual funds, index funds, and exchange-traded funds (ETFs), a self-directed Roth IRA allows you to expand your investment into assets like real estate, private equity, precious metals, and more. With more flexibility and control over your choice of assets, you can diversify and potentially capitalize on different investment strategies.

Advantages and benefits

A Roth IRA offers several advantages that can enhance your retirement strategy. This type of account offers more flexibility in managing your investments and provides a level of accessibility to your funds in case of emergency financial needs.

• Tax-free withdrawals in retirement: Qualified withdrawals after the age of 59½ from a Roth IRA are tax-free, including both contributions and investment earnings. That means you pay no tax at all on your earnings if you follow the withdrawal rules.

• No required minimum distributions (RMDs): Unlike traditional IRAs, Roth IRAs do not have required minimum distributions, or mandatory withdrawals, during the account holder’s lifetime. That allows you to keep your money growing in the account for as long as you like, and even pass it on to your heirs.

• Penalty-free withdrawal of contributions: Roth IRA accounts allow you to withdraw your contributions at any time without incurring penalties or paying additional taxes. Note that this applies only to the after-tax money you have directly contributed, not to earnings on your investments.

Disadvantages and limitations

Before you open a Roth IRA for your retirement plan, it’s important to acknowledge its potential disadvantages, specifically when it comes to your tax bracket and filing method. Depending on your income, marital status, and how you choose to file your taxes, you may be ineligible or your maximum contributions may be limited.

• Income limitations on eligibility: In 2024, individuals making $161,000 or more per year cannot contribute, and those making $146,000 or more per year are subject to a lower contribution limit. Married couples filing jointly and making $240,000 or more per year are ineligible, and those making $230,000 or less than $240,000 are also limited to a lower contribution amount.

• Contributions are not tax-deductible: Unlike 401(k)s and traditional IRAs, contributions to a Roth IRA are made with after-tax income, so you cannot deduct them from your taxable income for the year.

What is a 401(k)?

A 401(k) is a retirement saving plan offered by employers in which you can put a portion of your pre-tax income into an investment account. Because you’re contributing money before it’s taxed, putting funds into a 401(k) reduces your taxable income, which may reduce the amount you pay in taxes during the years you contribute. Your employer might also match a portion of your contributions, adding money to your 401(k) account on your behalf. And you can roll the account over if you change jobs.

Eligibility requirements

To contribute to a 401(k), individuals must meet certain eligibility requirements set by their employers. These requirements may include factors such as being at least 21 years old, completing a specified period of service with the company, or being classified as a full-time employee. Employers have the discretion to set additional eligibility criteria for their 401(k) plans, so it’s important to consult the plan’s documentation or your HR department to understand your specific requirements.

Contribution limits and deadlines

The annual cap on 401(k) contributions is significantly higher than the limit for Roth IRA accounts. For 2024, the contribution limit for 401(k) plans is $23,000. Additionally, employees over the age of 50 can contribute another $7,500 as part of a catch-up contribution. Unlike Roth IRAs, which have a 2024 tax year deadline of April 15, 2025, all contributions to a 401(k) must be made by December 31, 2024.

Tax implications

The tax advantages differ between a Roth IRA vs. a 401(k), with the primary distinction being when taxes are assessed and how taxes are applied to contributions and earnings.

1. Contributions: Contributions to a 401(k) are made with pre-tax income, meaning they are deducted from your paycheck before taxes are applied.

2. Earnings: Contributions and any investment earnings in a 401(k) are taxed when withdrawn in retirement.

3. Withdrawals: Withdrawals from a traditional 401(k) are subject to ordinary income tax rates at the time of withdrawal.

Investment options and flexibility

The investment options within a 401(k) are typically limited to a selection of funds chosen by the employer or plan administrator. These funds often include a range of mutual funds, such as stock funds, bond funds, and target-date funds. However, compared to other retirement plan options like IRAs, 401(k) accounts generally have fewer investment choices.

Advantages and benefits

Investing in a 401(k) offers several advantages, including the ability to contribute more through matching contributions from your employer, higher limits to your contributions, and the potential to lower your annual taxable income.

• Employer matching contributions: Many employers offer a matching contribution to employees’ 401(k) accounts as a benefit of employment. This matching contribution can significantly boost your retirement savings over time.

• Higher contribution limits: Compared to IRAs, 401(k) plans allow for higher annual contribution limits, allowing you to put away more toward retirement.

• Pre-tax contributions reduce taxable income: Contributions to a traditional 401(k) are made with pre-tax income, reducing your taxable income for the year. Additionally, both contributions and investment earnings grow tax-deferred until withdrawal in retirement.

Disadvantages and limitations

Investing in a 401(k) account also comes with certain potential challenges. Consider the following factors:

• Limited investment options: Compared to Roth IRAs, 401(k) plans typically offer a limited menu of investment choices, which are often pre-selected by your employer. This leaves you with less control and flexibility when it comes to how you invest your money.

• Required minimum distributions starting at age 73: Once you reach age 73, you’re generally required to start taking minimum distributions, or mandatory withdrawals, from your 401(k) account. These are subject to taxes at the rate of the time of withdrawal which may impact your cash flow in retirement.

Roth IRA vs. 401(k): how do they compare?

Both Roth IRAs and 401(k)s offer valuable tax advantages and opportunities for achieving your financial goals over the long term, but they have distinct features that can significantly impact the money you’re able to save for retirement. While a Roth IRA allows for tax-free withdrawals in retirement and greater control over investment choices, a 401(k) offers the potential for employer-matching contributions and higher contribution limits.

Factors to consider when choosing between a Roth IRA and 401(k)

When weighing a Roth IRA vs. a 401(k) for your retirement planning, take into account all aspects of your financial picture, including your earnings, tax bracket, and short- and long-term goals.

• Current and projected income: Contributions to a 401(k) are made before taxes, which can lower your current tax burden. And if you expect to be in a lower tax bracket after you retire, it may benefit you to pay taxes on your contributions at that time. By deferring tax payments, you can potentially enjoy tax benefits while saving for retirement.

• Tax bracket and expected future tax rates: If you expect to be in a higher tax bracket at age 59½ than you are now, a Roth IRA allows you to pay income tax on your contributions at your current rate, then enjoy tax-free withdrawals later.

• Employer contributions and matching: If your employer offers a matching contribution, taking full advantage of this benefit can help you put away even more money for retirement. That money is part of your total compensation package, but you only get it if you contribute to your 401(k).

• Investment options and preferences: A Roth IRA typically offers a broader range of investment choices compared to the limited options offered with a 401(k). If you prefer more control over your investment strategy, a Roth IRA may interest you.

• Long-term retirement goals and financial plans: Consider the role your account will play in your overall financial plan. Evaluate factors such as your desired lifestyle in retirement, your liquidity needs, and other sources of income. If you hope to retire early, for instance, you may appreciate the ability to withdraw your contributions from a Roth IRA without penalty.

• Risk tolerance and investment strategy: A Roth IRA offers more control over investment choices, allowing you to tailor your portfolio to your risk tolerance and investment preferences. A 401(k) may have limited investment options, but it can still be suitable if the available choices align with your investment strategy.

Roth IRA vs. 401(k): which is right for you?

Both Roth IRAs and 401(k)s feature unique benefits, limitations, tax advantages, and investment options to evaluate as you choose the right retirement plan for you. And it’s simple to open either type of account and start making contributions.

And you don’t have to decide between a Roth IRA vs. 401(k); you’re allowed to have both types of accounts. If you’re already contributing to your employer’s 401(k), opening a Roth IRA can be an opportunity to save more for retirement. Depending on your overall financial goals, you may even wish to explore more types of investment accounts for building long-term wealth.

Whichever path you choose, the earlier you start saving for retirement, the more time your investment will have to grow.

Roth IRA and 401K FAQ

Can you invest in both a 401(k) and a Roth IRA?

You can have both. Even if your employer offers a 401(k), you can open a Roth IRA and contribute up to the maximum allowed for each account. If saving for retirement is a high priority for you, this can be a good way to maximize the amount you can invest.

If your employer offers matching contributions, you may want to contribute enough to get the full match, and then invest in a Roth IRA. If you’re able to fully fund the Roth IRA, you can put any additional deposits into the 401(k), up to the annual limit.

When should you not invest in a Roth IRA?

With any tax-advantaged retirement account, you’re trading tax benefits for keeping money in the account until retirement. So if you expect to need your money before you reach retirement age, a Roth IRA may not be the right choice for you. Also, if you expect to be in a lower tax bracket when you retire than you are now, you might save money by paying taxes when you withdraw money, rather than when you contribute it. Finally, if reducing your tax burden now by investing pre-tax dollars is important, a Roth IRA won’t give you that advantage.