When you start saving for retirement, you will more likely start with a Roth IRA and 401(k) plan from your job. These two accounts are the most used retirement plans together with a traditional IRA. To maximize your retirement savings, however, you will need to know the key differences between a Roth IRA and a 401(k). There are benefits and drawbacks of opening a Roth IRA vs. a 401(k) plan or both. If you can master these differences, you can easily make substantial progress on your retirement savings and take advantage of tax benefits associated with each plan.
In this article, I will walk you through the key differences between a 401(k) vs. a Roth IRA and how to take advantage of each plan to maximize your tax benefits.
What is a Roth IRA?
A Roth IRA is a retirement account where contributions come from after-tax money. With a Roth IRA, you grow your account tax-free and pay no income tax on your withdrawals during retirement.
Roth IRAs are not offered by employers. Instead, you open a Roth IRA from your local bank, credit union, brokerage firm, or similar financial institution. A Roth IRA is good for you if you are OK with paying taxes now and prefer to not pay tax on your withdrawals during retirement.
Unlike 401(k) which offers direct tax benefits, all contributions to a Roth IRA come from your after-tax wages.
Related: How to open a Roth IRA: Create a Roth IRA in 6 steps
What is a 401(K)?
A 401(K) is a retirement plan that is offered and sponsored by employers. When you have a 401(K) plan, your contributions come from before-tax wages through payroll deductions. For this reason, contributions to your 401(k) plan are tax deductible and you will grow your account on a tax-deferred basis. The catch is that you will pay an income tax on your withdrawals during retirement.
Many companies use 401(K) plans to attract talented employees by matching their contributions up to a certain percentage. Keep in mind that some companies also have a vesting period which is a time you must work for these companies before their contributions to your 401(K) become 100% yours.
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Roth IRA vs. 401(K) in a nutshell
There is a big difference between the Roth IRA vs. 401(K). Here is how the 401(k) and the Roth IRA differ in a nutshell.
- 401(K) plans are only offered through employers and you may get a matching percentage. The Roth IRA, on the other hand, is not provided by your company. Instead, you can open a Roth IRA with financial institutions such as banks, credit unions, or brokerage companies.
- Contributions to your 401(K) plan come from before-tax money through payroll deduction. On the other hand, contributions to your Roth IRA come from your after-tax money. You can transfer funds to your Roth IRA directly from your checking or savings account.
- You grow your 401(k) account on a tax-deferred basis while you grow your Roth IRA tax-free
- Withdrawals from your 401(k) plan are subjected to federal and state income tax while Roth IRA withdrawals are tax-free.
- With a Roth IRA, you make contributions with after-tax money, grow your account tax-free, and pay no tax during retirement on your distributions.
- For the 401(k), you make contributions with before-tax money, defer your taxes, and pay income tax when taking the money out.
- For contribution limits, 401(k) allows much higher contribution limits than a Roth IRA. In 2024, you can contribute up to $23,000 to your 401(k) or $30,500 if you are 50 or older. For the Roth IRA, you can contribute $7,000 or $8,000 if you are 50 or older.
- Your 401(k) plan is managed by the company and you can only invest in investment options inside the plan. For the Roth IRA, you manage your account and have access to a wide range of investment options such as ETFs, mutual funds, stocks, and Bonds.
- You can transfer your Roth IRA account to your heirs tax-free. For the 401(k), your heirs must pay income tax.
Roth IRA vs. 401(K)
| Roth IRA | 401(K) Plan |
| Contributions are not tax deductible | Contributions are tax-deductible |
| Contributions are tax-deductible | You contribute before-tax money |
| Lower contribution limit: For 2024, your Roth IRA contribution limits $7,000 or $8,000 if you are 50 or older. | Higher contribution limit: For 2024, the contribution limits to a 401(K) plan are $23,000 or $30,500 if you are 50 or older. |
| There is no employer match | Possible employer match up to a certain percentage |
| Has a wider range of investment options | Limited investment options |
| You can shop around for fewer fees | comes with higher fees |
| Do not have required minimum distributions(RMDs) at 73 | Come with required minimum distributions (RMDs) when you turn 72 |
| No income tax on qualified withdrawals | You pay an income tax on your distributions during retirement |
| You grow your account tax-free | You grow the account on a tax-deferred basis |
401(K) vs Roth IRA: Which one is better?
Picking the right retirement plan is essential in securing a solid financial future. Both 401(K) and Roth IRAs come with impressive tax advantages that are unique to each account. If you pick a Roth IRA, you will pay more tax upfront but your withdrawals will be tax-free. On the other hand, if you pick a 401(k), you will defer taxes now only to pay higher taxes during retirement.
When comparing the Roth IRA vs. 401(K), you need to evaluate your retirement savings goals and how each plan will help you reach those goals.
Open a Roth IRA if you don’t want to pay taxes on your withdrawals during retirement. A Roth IRA will also be good for you if you are anticipating a higher retirement income since distributions from your Roth account will help you minimize your tax liabilities.
If you want to minimize your current income tax and grow your wealth faster, open a 401(K) plan. All contributions to the plan will be tax-deductible and you might get an employer match.
You might also like: How many IRAs can you have in 2024?
Best retirement saving strategy: Have both 401(k) and Roth IRA
To take advantage of all the benefits that come with a Roth IRA and 401(k), open both accounts. With the 401(k) plan, you will lower your current income tax, defer tax, and grow your net worth faster. Additionally, you will enjoy free money through your employer’s matching percentage.
Having a Roth IRA in conjunction with A 401(k) plan will help you grow your wealth even faster and help you retain all your earnings. Not only that you get to save more money toward your retirement, but you also keep every dollar you make with your Roth IRA. Additionally, Roth IRAs do not come with RMDs and you can transfer your account to your descendants tax-free.
With this strategy, instead of saving only $23,000 to your 401(k) or $7,000 to your Roth IRA, you will save a total of $30,000 for both accounts. And if you are 50 or older and choose to max out both accounts, you will save $38,5000 without including the employer match.
Related: Can you have a 401(k) and an IRA at the same time?
How much should you contribute to a Roth IRA and a 401(K)?
This is the most exciting part. Now that you understand the basics of 401(K) vs. Roth IRA, how much should you contribute to each account?
If you are going to have both 401(K) and Roth IRA, it would make sense to make contributions that maximize your retirement savings and reduce taxes at the same time. To take full advantage of both accounts, max out each account every year. For the 401(k), contribute the maximum allowed of $23,000 in 2024 or $30,500 if you are 50 or older. For the Roth IRA, contribute $7,000 in 2024 or $8,000 if you are 50 or older.
If you cannot afford to max out each account every year, use the following strategy.
The first thing you should always do is contribute an amount equal to your employer’s matching percentage for a 4001(K) plan. You don’t want to leave free money on the table. If your main focus is to reduce your taxable income, then add more contributions to your 401(K). This way you will end up paying less tax each year you make higher contributions to your 401(K).
If you are not interested in lowering your taxes now and are worried about paying taxes during retirement; switch your focus from 401(K) to Roth IRA after contributing up to your employer’s matching percentage. Also, if your employer does not offer a matching percentage and you are not interested in reducing your taxes; keep your focus on Roth IRA. Your Roth IRA will let you grow your account tax-free and you will not pay income tax on acceptable withdrawals during retirement.
In addition, your Roth IRA will come with a much wider range of investment options and your fees will be lower. By default, 401(K) accounts come with higher fees and limited investment options.
Take away: Contribute up to your employer matching percentage, then max on your Roth IRA. If you still have more money to contribute, add it to your 401(K) contributions.
Required Minimum Distributions(RMDs)
Some retirement plans such as 401(K)s, SEPs, and Simple IRAs come with required minimum distributions (RMDs). For 2024, the RMDs are applied when you reach 73 years old. The IRS denoted that If you fail to take required distributions or take lower than the required amount; you will be subjected to a 50% excise tax on the amount you were supposed to withdraw but chose not to. For example, if you were supposed to withdraw $4,000 but only withdrew $3,000; you will pay a 50% excise tax on the $1,000 you left in the account.
Roth IRAs do not have minimum distribution requirements (RMDs) in your lifetime. This is an extra benefit of having a Roth IRA vs. 401(K). According to Investopedia, the heirs to your Roth IRA will be required to take RMDs except for your spouse.
Early withdrawals penalty on 401(K) in 2024
Your 401(K) plan or any other retirement account is like a contract you sign with the government. For your 401(K) plan, the IRS lets you put away pre-tax money toward retirement savings. In return, you agree to not make withdrawals until you retire. When you fail to follow this rule and many more that govern your 401(K) plan, you pay a penalty.
One of the penalties you will pay is the early withdrawal penalty. According to the IRS, withdrawing money from your 401(K) plan before you reach the age of 59 1/2 will result in a 10% penalty on your distributions. On top of that, you will pay an income tax on the money you took out.
For example, if you withdrew $100,000 from your 401(K) before you reach 59 1/2, you will pay around $10,000 in penalty. On top of this 10% penalty; you will pay an income tax on the amount you withdrew. After all these deductions, you may end up taking home only $55,000.
In some cases, the 10% extra tax may be waived if you meet the IRS exceptions.
Early withdrawal penalty on Roth IRA in 2024
The early withdrawal penalty on a Roth IRA is a little different from the 401(K) plan. For the Roth IRA, the 10% penalty is applied only if you withdraw money from your account before you turn 59 1/2 and your Roth IRA account is less than 5 years. In any other situation, you can withdraw money from your Roth IRA without paying a penalty. The IRS could waive this penalty if you meet some of its exceptions.
According to Charles Schwab, the early withdrawal penalty on a Roth IRA could be waived if you are using the proceeds for college expenses, covering adoption expenses, due to disability, or buying a home for the first time.
If you can manage to put the money back into your Roth IRA account or another qualifying retirement account within 60 days, the IRS may not consider the transaction as an early withdrawal. Failure to deposit the money back into the account will result in an early withdrawal and you could pay a penalty.
401(K) contribution limits in 2024
The maximum contribution you can make to your 401(K) in 2024 is $23,000 or $30,500 if you are 50 or older. For 2023, you can contribute up to $22,500 to your 401(k) or $30,000 if you are 50 or older.
Roth IRA contribution limits in 2022
The maximum contribution you can make to your Roth IRA in 2024 is $7,000 or $8,000 if you are 50 older. For 2023, you can contribute up to $6,500 to your Roth IRA. If you are 50 or older, you can contribute an extra $1,000 catch-up contribution to your Roth account.
