Roth IRAs and 401(k)s: Which Is the Better Choice for You?

Nov 9

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The path to a comfortable retirement is paved with several financial decisions; one of the most significant is deciding which retirement accounts to invest in. In this article, we'll guide you through the intricacies of two tax-advantaged retirement accounts: Roth IRAs and 401(k)s. More specifically, we’ll focus on the unique features and benefits of each and provide you with the necessary insights to determine which one is the best fit for your own personal retirement savings strategy.

What is a Roth IRA?

As with a traditional IRA, a Roth IRA is an account designed specifically to help fund your retirement. You can invest in various assets within the account such as stocks, bonds, ETFs, and mutual funds.

However, unlike traditional IRAs—wherein tax breaks are often immediate (if funding with pretax dollars)—Roth IRA tax breaks come later as contributions are typically made with after-tax dollars. This arrangement offers a significant advantage: all your withdrawals during retirement are tax-free, provided you’re older than 59½ and have owned the account for at least five years (known as the “five-year rule”).

What is a 401(k)?

A traditional 401(k) is an employer-sponsored retirement account that comprises various investments—typically stocks, bonds, and mutual funds—and one you can select either by yourself or with the help of a financial advisor. Participants invest a percentage of their pretax income (with the money automatically coming out of their paychecks) to fund their account, and as an added benefit, most employers match employee contributions (up to a predefined percentage): which is essentially “free money” for the participating employee.

With 401(k) accounts, your funds can grow tax-free—meaning you’ll only pay taxes on money in your account after making a withdrawal.

Key differences between Roth IRAs and 401(k)s

Tax treatment
As mentioned earlier, one primary difference between a Roth IRA and 401(k) lies in their tax treatment. While the former is funded with after-tax income—making your withdrawals tax-free during retirement—the latter is funded with pre-tax income, subjecting your withdrawals to taxation upon retirement.

RMDs
Your 401(k) includes required minimum distributions (RMDs), which are the minimum amount of dollars one must withdraw from specific tax-deferred retirement accounts beginning at age 73 (as of January 1, 2023). Starting in 2033, this stipulation will climb to age 75.

Because Roth IRAs are funded with after-tax dollars, these types of accounts don't have any RMD stipulations: allowing investments to grow tax-free indefinitely.

Withdrawals
Although some exceptions do exist, anyone looking to withdraw from a 401(k) prior to age 59½ is subject to a 10% early withdrawal penalty from the IRS and must pay taxes on the withdrawal—assuming his or her employer allows early withdrawals.

Upon turning 59½ years old, however, you can withdraw money from your 401(k) without paying an early withdrawal penalty—though the amount is considered income and consequently subject to taxes.

Roth IRAs allow investors to withdraw sums equivalent to contributions they’ve made, both penalty and tax-free and at any time and for any reason. Those over the age of 59½ who want to withdraw from the earnings portion of the account can do so tax-free, provided they’ve owned the account for at least five years; earlier withdrawals may result in a 10% early withdrawal penalty and a requirement to pay taxes on these earnings. As with 401(k)s, there are exceptions to every rule—Roth IRAs are no different.

Eligibility
Your eligibility hinges on whether or not your employer offers a 401(k). If they do, you may be subject to a minimum age (often 21) or service requirement before becoming eligible. In contrast, Roth IRA eligibility doesn't involve an employer but is instead based on income.

For example, if you are a single filer with a modified adjusted gross income (MAGI) exceeding $153,000 in 2023, you are not eligible to contribute to a Roth IRA; moreover, if your MAGI is more than $138,000 but less than $153,000, you can only contribute a reduced amount. For those filing jointly, the maximum MAGI limit is $228,000 based on contribution qualifications (with the maximum allowed annual contribution reduced if your joint MAGI is more than $218,000 but less than $228,000).

If you’re a high-income earner (exceeding the above income thresholds), you can still contribute to a Roth IRA but must do so via an IRS-approved method called a backdoor IRA. There are several ways to create a backdoor Roth IRA, each requiring you convert at least a portion of traditional IRA funds to a Roth IRA.

Contribution limits
The major appeal of a 401(k) is its high contribution limit, allowing contributions up to $22,500 in 2023 ($30,000 for those aged 50 or older)—exceeding Roth IRA limits.

If you are under 50, the maximum annual Roth IRA contribution limit is $6,500 in 2023 (those age 50 or older can contribute up to $7,500).

Higher contribution limits for those age 50 and older are deemed a “catch-up contribution,” offered by the IRS to encourage savings and help ease the financial burden of retirement—especially for those who failed to save enough when they were younger.

Investment opportunities
Roth IRAs and 401(k)s provide various investment avenues, each with its own unique advantages. When you opt for a 401(k), investment choices are bound by the options your plan administrator offers. On the other hand, a Roth IRA affords you greater autonomy over your investments. As you manage your account (or entrust it to a financial advisor), you have the power to dictate how you want your assets allocated: a level of flexibility that can give investors additional options to meet their investment objectives.

How to choose between a Roth IRA and 401(k)

You'll need to consider various factors when deciding between these options. Let's use two different scenarios to illustrate this concept:

Scenario #1: Choosing a 401(k). If your employer offers to match your 401(k) contributions, this should shine through as the better choice as the match effectively adds "free" money to your retirement savings.

Scenario #2: Opting for a Roth IRA. Let’s say you're at an early stage of your career and your income is relatively low, but you anticipate it will rise significantly over time and thus push you into a higher tax bracket during retirement. In this case, a Roth IRA is perhaps the more suitable option as you can contribute post-tax dollars now—while your tax rate is low—and then enjoy tax-free withdrawals in retirement when your tax rate is likely higher.

It’s easy to see that the decision to opt for either a Roth IRA or 401(k) depends largely on your own unique financial circumstances, current and future tax rates, and the investment options available to you.

Effectively blending 401(k) and Roth IRA investment options

It’s a common misconception that one must choose solely between a Roth IRA and 401(k). However, this isn't necessarily the case! You can strategically use both accounts to amplify your retirement savings, but how should you go about doing so? Here's a popular approach:

Step #1: Prioritize employer match. If your employer offers a 401(k) match, you should first contribute enough to secure the full match percentage—essentially free money you shouldn't let slip through your fingers. For example, if you earn $100,000 and your company match is 5%, you should contribute a minimum of $5,000 annually.

Step #2: Max out your Roth IRA. After securing the employer match, turn your attention to a Roth IRA and aim to contribute up to the annual limit. Why? A Roth IRA allows your investments to grow tax-free, delivering substantial long-term benefits.

Step #3: Return to your 401(k). If you still have funds left to invest after maxing out your Roth IRA, it's time to circle back to your 401(k) and contribute the remaining amount to this account. While your 401(k) contributions won't grow tax-free, they will still provide valuable tax advantages.

In sum: deciding between Roth IRAs and 401(k)s

It’s not a question of which account is better; it’s about which best fits your needs. If you’re eligible for both accounts, you should likely take advantage of both so you don’t leave money on the table (employer match) and miss out on all tax benefits associated with a Roth IRA.