Roth IRA vs. 401(k): What’s The Difference and Which One Is Better?

Planning for retirement is a crucial aspect of financial well-being. With many retirement investment options available, choosing the right retirement savings account can be challenging.

This article will explore two popular retirement savings accounts: the Roth IRA, an Individual Retirement Account, and the 401(k), an employer-sponsored retirement account. We’ll discuss the benefits of each — as well as key differences — while addressing how to choose the best option based on your personal financial situation.

What is a Roth IRA?

A Roth IRA is an Individual Retirement Account that anyone can open independently, regardless of their job or employee status. You only need to have earned income for the year and fall below IRS income limits to make direct contributions.

Unlike a traditional IRA, you make Roth IRA contributions after you pay income tax, allowing you to make tax-free qualified withdrawals in retirement — provided you’ve had your account open for at least five years and have attained at least age 59.5.

Because you manage the account rather than your employer, you tend to have a wider variety of investment options and can exert greater control over the account, particularly with regard to its location.

Top Benefits of a Roth IRA

Using your earned income to invest in a Roth IRA can provide you with numerous financial benefits in retirement. Some of those key advantages include:

• Variety of investment options: Roth IRAs offer a more comprehensive range of investment choices than 401(k)s, which are more limited to a small pool of mutual funds or ETFs offered by your plan provider. With an IRA, you can work with a financial advisor or a robo-advisor to determine if you want to invest in index funds, ETFs, mutual funds, precious metals, and more. You can also self-direct your Roth IRA if you wish.
• Tax-free growth: Since you invest in a Roth after you’ve paid taxes, you can withdraw the funds without paying taxes in retirement. Essentially, all the money that grows in the account is tax-free money so long as you meet IRS guidelines regarding qualified distributions.
• No RMDs (Required Minimum Distributions): Unlike traditional IRAs and tax-deferred 401(k)s, Roth IRA account holders are not required to withdraw a certain amount of money each year once they reach their early 70s. If you don’t need the funds, you can let them grow endlessly and potentially pass the money down to your beneficiaries.
• Does not need to be employer-sponsored: Roth IRAs can be opened independently; that is, without employer sponsorship. This means you can open a Roth IRA even if you’re self-employed, a contract worker, or someone whose job doesn’t offer 401(k) retirement benefits. It also means you can keep the account for life, even as you change jobs.

Roth IRA Contribution Limits

Despite the immense potential tax benefits of a Roth IRA, the annual contribution limits are lower than those of a 401(k). Additionally, Roth IRAs come with income limits; earners in higher tax brackets are generally ineligible for direct contributions to Roth IRAs.

The IRS outlines that any individual with a Modified Adjusted Gross Income (MAGI) of over $153,000—or a married couple filing jointly with a combined MAGI of $228,000 or more—are not eligible to contribute.

In those financial situations, a traditional IRA is an alternative option.

The maximum annual contribution for a Roth IRA in 2023 is:

• For those who are under 50: $6,500
• For those who are aged 50 or older: $7,500

Withdrawal from Your Roth IRA

You can withdraw your Roth IRA contributions at any time and age without tax liability or penalties. That refers to the funds you put in, not the market gains on those funds.

If you make withdrawals on earnings from your investment choices, you may have to pay income taxes and a 10% early withdrawal penalty, which exists to prevent people from taking their retirement savings and using them for other personal finance needs prematurely.

One unique feature of Roth IRAs is that they have no Required Minimum Distributions (RMDs) in your retirement years. Unlike 401(k)s or traditional IRAs, which mandate that you begin taking regular withdrawals at age 73, with a Roth IRA, you can leave the money in the account for the rest of your life.

If you take withdrawals from your Roth IRA before age 59.5, you will incur an early withdrawal penalty of 10% on the entire amount withdrawn — unless you fall into one of the IRS exception categories. As long as your account is five years old, you may be able to avoid both penalties and taxes on the earnings portion of your withdrawal if you meet the following exception criteria:

• Withdrawn due to permanent disability: You must provide proof.
• Withdrawn by your beneficiary after your death: Your account beneficiaries are entitled to the remaining money.
• Withdrawn to purchase or build your first home: If you’re a first-time homebuyer, you’re entitled to withdraw up to $10,000 to help finance your purchase. This is a lifetime limit.

What is a 401(k)?

A 401(k) is an employer-sponsored retirement savings account and gets its name from its mention in section 401(k) of the Internal Revenue Code. Unlike a Roth IRA account, with a traditional 401(k), you must be an employee at a company that offers one to participate.

When you have a tax-deferred 401(k), you make contributions using pre-tax dollars, meaning that the money is deducted from your paycheck and invested in the account before income tax is calculated. As a result, your contributions are tax-deductible and can help you lower your overall income tax rates for the year.

But, like any pre-tax account, when you withdraw funds in retirement, you’ll owe ordinary income tax. There will also be Required Minimum Distributions beginning at age 73.

There are various types of 401(k) accounts and retirement plan providers, depending on the options offered by your employer. An added benefit of a 401(k) is the option for employer matching. This means if you commit to contributing a percentage of your salary, your employer may match a portion of that contribution every year, essentially offering you free money.

Unlike a Roth IRA, 401(k)s have no income limit regarding eligibility.

Roth 401(k)s — to which you use after-tax money to make contributions — are offered by some employers.

401(k) Contribution Limits

401(k) accounts have much higher contribution limits than Roth IRAs. Your contribution is classified as your employee contribution, while your total contribution includes your employer match, if applicable.

We mentioned the benefit of an employer match above, which allows you to gain additional savings from your employer. When calculating matching contribution limits, there are caps on your individual contributions and the total, including your employer’s contribution.

The 2023 contribution limits are as follows:

• For those under 50: $22,500 of employee contributions, $66,000 total, including employer contributions.
• For those aged 50 or older: $30,000 of employee contributions (including a catch-up contribution of $7,500), $73,500 including employer contributions.

401(k) Benefits

Many 401(k) features make the account a smart choice for retirement savings. The main benefits include:

• Employer match: Employers may offer to match employee contributions up to a certain percentage, essentially providing free money for retirement savings. Not all employer plans offer this, so be sure to ask for more information if you have a 401(k). If they do provide a matching program, make use of it whenever possible.
• Higher contribution limits: 401(k) plans have higher annual contribution limits than Roth IRAs, allowing you to save more — especially if you consider the added employer match.
• Employer contributions: Employers may contribute to an employee’s 401(k) plan, providing an additional source of retirement savings and effectively boosting your compensation without putting you in a higher tax bracket.
• Tax-deferred: Contributions to a tax-deferred 401(k) plan are made using pre-tax dollars, which lowers your taxable income for the year. Unless you’re working with a Roth 401(k), you won’t be eligible for tax-free withdrawals in retirement, since you were able to benefit from tax deferral when you first made contributions.

In Summary

A Roth IRA is an individual retirement savings account that anyone can open. It offers a variety of investment options and tax-free growth. It is ideal for those who expect to be in a higher tax bracket during retirement than they are during their working career.

A 401(k) is an employer-sponsored retirement plan with higher contribution limits than a Roth IRA. This option is suitable for those who work in a structured employer-employee format and want to maximize their retirement savings through tax-deferred contributions and possible employer contributions.

Choosing the right retirement savings account depends on your financial situation, goals, and preferences. Getting trusted guidance in this process is essential to select the best option for your needs.

Capitalize acts as a partner that can help you navigate the complexities of the retirement savings landscape and ensure that you manage the entire process successfully.

Take the first step towards securing your financial future and get started with Capitalize today.