Unless you’re deeply passionate about your job, you probably want to retire someday. And who can blame you? We all have dreams we want to accomplish, and most of those dreams have nothing to do with work. Maybe you want to travel the world or get your pilot’s license. These things are harder to do when you’re working a 9-5.
But like all worthwhile things, retirement requires planning and preparation. You’ll have to make many decisions about how to handle your savings, and how to make sure your retirement funds grow as quickly as possible. Perhaps the most important of these decisions is which type of retirement fund you want to invest in. Two of the most popular options are Roth IRAs and 401(k)s.
Which one is right for you? That depends on your personal financial situation. But once you know how both types of funds work, you’ll be able to determine which is best for you needs. Let’s compare a Roth IRA vs. 401(k), and see how they compare!
What Is a Roth IRA?
A Roth IRA is a special type of individual retirement account (IRA). You open this account at a financial institution, such as a bank, and make contributions from your after-tax income. Because you’ve already paid taxes on your contributions, you’ll eventually be able to withdraw that money tax-free.
This is different from a traditional IRA, which is funded from pre-tax income. With a traditional IRA, you pay taxes on your withdrawals instead of your contributions.
Advantages of a Roth IRA
So, why would you invest in a Roth IRA, rather than a 401(k)? Here are a few reasons:
It’s not tied to your employer. With a 401(k), you can’t keep contributing to the same account when you switch jobs. Instead, you’ll have to roll over your old 401(k) into your new one, or keep track of every 401(k) you’ve ever contributed to. With a Roth IRA, your retirement fund travels with you from job to job.
The money is tax-free. 401(k) withdrawals are taxed as ordinary income. When you’re retired and living on a fixed income, the last thing you need is more tax liability. With a Roth IRA, you don’t owe any taxes on your withdrawals. This doesn’t just apply to the money you’ve deposited, either. It also applies to the growth, which will form the bulk of your money. Over your lifetime, this can save you tens or even hundreds of thousands of dollars in taxes.
Nonworking spouses can participate. If one spouse is the sole breadwinner, the other spouse doesn’t have to be left out. The employed spouse can invest in their own Roth IRA, as well as investing the full maximum in their spouse’s IRA. With a 401(k), there are no benefits for the non-earning spouse.
No mandatory withdrawals. With a 401(k), you have to start withdrawing a minimum amount per year, starting at age 72. With a Roth IRA, you can retire on your own timetable. If you want to let your fund keep growing until you’re 80 years old, you’ll be able to. This is perfect for people who love their jobs, but still want to have an income should they become too infirm to work.
More flexibility. 401(k)s will only let you invest in a handful of funds, which the plan’s administrator chooses. On the other hand, Roth IRAs can have hundreds or thousands of investments to choose from. As a result, you have more control over your financial future.
Disadvantages of a Roth IRA
As with any investment instrument, Roth IRAs have their share of drawbacks. Here are some things you should think about before you open an account:
There are strict contribution limits. Roth IRAs have a $6,000 annual limit for contributions, which goes up to $7,000 per year for people’s aged 50 and older. By comparison, 401(k) plans have a much higher contribution limit.
Not everyone can invest. There’s actually an income limit for Roth IRAs. If you earn over $144,000 per year ($214,000 for married couples filing jointly), then you won’t be allowed to contribute. In that case, you’ll need to rely on a 401(k) or a traditional IRA.
There’s a time limit. When you open a Roth IRA account, that account must remain untouched for at least five years, or you’ll have to pay a penalty. This won’t be relevant for most people, but it’s worth taking into consideration. Moreover, you’ll pay income tax on any withdrawals made before age 59 ½. But you won’t pay any additional penalties for an early withdrawal.
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What Is a 401(k)?
Compared to Roth IRAs, 401(k) plans have been around for longer, and are better known. These are your standard employer-sponsored retirement accounts that come along with most jobs. To contribute to a 401(k), you set aside a percentage of each paycheck to go into the account. This money is not taxed at the time, but you pay ordinary income tax on any withdrawals.
In addition to your own contributions, most 401(k) plans come with an employer match. Employers will match an employee’s contribution on a dollar-for-dollar basis, or as a percentage of their contribution. There will also be a limit to how much the employer will match. For example, your employer might match 50% of your contributions, up to a maximum of 5% of your salary. So if you contributed 10% of your salary, you’d get an additional 5% match.
Advantages of a 401(k)
Here are some of the advantages of a 401(k) plan:
You get an employer match. We already talked about this, but it bears repeating. With an employer match, you’re basically giving yourself a free raise! Make sure to check out your plan’s specifics, though. Not all employers offer a matching contribution.
Less short-term tax liability. Because you’re investing pre-tax dollars, your contributions are tax-deductible. In some cases, this might even put you into a lower tax bracket!
You can contribute more money. 401(k) plans allow for an annual contribution of $20,500 per year, which is nearly three times as much as you can invest in a Roth IRA. Not only that, but individuals aged 50 and over can contribute up to $27,000. Better yet, your employer matching contribution doesn’t count towards this limit.
There’s at least some portability. While you can’t take a 401(k) with you from job to job, the money is still yours. You can let it sit and continue to grow, or roll your money over into another 401(k), a Roth IRA, or even a traditional IRA.
Disadvantages of a 401(k)
Just like a Roth IRA, a 401(k) comes with its own share of drawbacks. Here are a few of them:
Your withdrawals are subject to tax. While you don’t have to pay taxes on your contributions, you’ll be taxed on any withdrawals. This includes all the gains you’ve gained over the years, which can amount to a hefty sum.
You have less flexibility. Most 401(k) plans are managed by a plan administrator, who selects the funds you can invest in. Usually, you’ll only have a small number of options, which means you have far less control over your investments.
You need to be employed by someone else. If you’re self-employed, you won’t have access to a 401(k) plan. Even when you’re employed by a company, there’s normally a waiting period before you’re allowed to participate. Roth IRAs, on the other hand, are not tied to your employment.
Mandatory withdrawals. Once you turn 72, you have to withdraw a certain percentage of your savings each year. Otherwise, you’ll face a tax penalty. Even if you’re still happily working and would like the money to keep growing, you’ll have no choice but to withdraw it. It’s also worth noting that you’ll pay a penalty for withdrawals made before age 59 ½.
Roth IRA Vs. 401(k): Key Differences
Roth IRAs and 401(k)s both give you a way to gain tax advantages while you’re saving for retirement. Other than that, they have very little in common. The most significant difference is the way they’re managed. A 401(k) is offered through your employer, and you have minimal hands-on involvement. With a Roth IRA, you’ll have more options, as well as more hands-on involvement.
Here are some other differences between the two.
Eligibility & Contribution Limits
Whether or not you’re eligible for a 401(k) depends on whether or not your employer offers one. Similarly, different employers will have different eligibility requirements for their employer match program.
Roth IRAs, on the other hand, are theoretically available to anyone who earns less than the maximum income. However, you have to find a financial institution that’s willing to work with you. Many banks have high minimum deposit amounts, which can be challenging if you’re earning a modest income.
That said, a Roth IRA is still worth considering for lower-income individuals. Because your withdrawals are tax-free, you won’t be under as much stress in retirement. You’ll be able to experience a higher standard of living with a lower overall account balance.
Along the same lines, Roth IRAs are less beneficial for high earners. With a maximum annual contribution of $6,000, you’ll often find that you want to save significantly more money. In that case, you can take advantage of a 401(k)’s higher limits.
With a 401(k), you can contribute up to $20,500, or $27,000 if you’re over 50. Not only that, but your employer match can put the total amount as high as $58,000 or 100% of your salary, whichever is lower.
Tax Treatment & Distributions
Regarding taxes, Roth IRAs and 401(k)s work entirely differently. Because your Roth IRA contributions are taxed, your withdrawals are tax-free. On the flip side, 401(k) contributions are not taxed, but you have to pay income tax on all of your withdrawals.
With a 401(k), you have to take required minimum distributions (RMDs), starting on your 72nd birthday. This allows the IRS to start collecting taxes as you withdraw your money. Because Roth IRA withdrawals are not taxed, there are no mandatory withdrawals. You can leave all your money in the account until you’re ready to start making withdrawals.
If you’ve had your Roth IRA for a minimum of five years, you can withdraw your money whenever you want, although withdrawals made before age 59 ½ will be subject to income tax. On the other hand, with a 401(k), you pay a 10% tax penalty on any early withdrawals, in addition to any income tax.
401(k) plans are administered by your employer, which means your employer chooses a menu of investments for you to choose from. The exact size of the menu varies from employer to employer, but you’re looking at a very limited number of options.
On the other hand, you manage your own Roth IRA plan. You can choose your own investment, or even subscribe to a robotic advisor service to manage your money. Depending on the IRA, you’ll have many more options, including ETFs and other low-fee investments that your employer might not offer.
Can You Have Both a Roth IRA & 401(k)?
At this point, you might be wondering if you can take advantage of both these retirement plans. As long as your employer offers a 401(k) and you don’t earn too much to contribute to a Roth IRA, the answer is yes. As a matter of fact, combining a Roth IRA and a 401(k) can be the best method of saving.
Here’s a good rule of thumb: an employer-matched 401(k) is better than a Roth IRA, which is better than a traditional IRA or non-matched 401(k). Why might this be the case?
With an employer-matched plan, it’s a no-brainer. While you’ll be taxed on your withdrawals, it simply makes no sense to turn down a free raise. While it doesn’t give you free money, a Roth IRA does give you tax-free withdrawals, which can net you a huge savings. Traditional IRAs and non-matched 401(k) plans offer neither of these benefits.
So, how do you allocate your savings to get the best benefit? Start out by contributing enough money to your 401(k) to maximize your employer match. So if your employer matches up to 5%, you’d contribute enough each week to get the full 5% match. After that, put the maximum amount into a Roth IRA, to take advantage of the tax-free growth.
As you can see, the optimal way to maximize your retirement savings is to pair a Roth IRA with a 401(k). Invest in the 401(k) up to your employer’s matching limit, and put the rest of your savings into a Roth IRA. If you can, invest 15% of your income.
Of course, not all retirement accounts are equal. Make sure you’re investing in funds with a strong track record. No investment is guaranteed, but the better the fund’s track record, the more likely you are to see good returns. Ask a financial advisor for assistance if you’re not sure to invest, and whatever you do, avoid investing in dubious investments like meme stocks.
If you have to decide between a Roth IRA vs. 401(K), make sure to start saving early. The sooner you begin putting money away, the more it will grow over time, and the larger your retirement savings will be.
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