401(k) vs. Roth IRA key differences
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“Verified by an expert” means that this article has been thoroughly reviewed and evaluated for accuracy.
BLUEPRINT
Updated 3:04 p.m. UTC Nov. 15, 2023
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Key points
- 401(k)s and Roth IRAs have different tax treatments.
- When choosing a 401(k) or Roth IRA, consider your financial circumstances.
- 401(k)s and Roth IRAs can be complementary tools in your retirement plan.
Imagine your journey to financial freedom as an epic game of tug of war. On one end of the rope is the 401(k), a workplace retirement plan that often boasts an employer match.
On the other is the Roth IRA, which has unique advantages that set it apart from the traditional IRA and allow you to avoid taxes on withdrawals in your golden years.
But this isn’t your typical tug of war. The winning strategy isn’t to pull harder but to find a balance between the two options that aligns with your financial goals and circumstances.
Datalign Advisory
Roth IRA vs. 401(k): How do they compare?
Traditional 401(k)s and Roth IRAs are “completely different types of accounts,” said Stuart D. Boxenbaum, a certified financial planner at Statewide Financial Group.
Roth IRAs are funded with after-tax dollars and offer a unique advantage: Your withdrawals are tax- and penalty-free as long as you have reached age 59½ and it has been at least five years since your first Roth IRA contribution. But there are limits to how much you can contribute to a Roth IRA each year.
Tip: You can withdraw your Roth IRA contributions — but not earnings — anytime tax- and penalty-free.
On the flip side, 401(k)s are funded with pretax contributions that are automatically deducted from your paycheck. They have higher contribution limits than Roth IRAs. But your investment options are limited to what your employer offers through your plan provider.
Both 401(k)s and Roth IRAs help you save for your golden years. But they do so in different ways. Each account has its own rules, benefits and limitations, so factors like your current and future income, tax situation, and financial goals are essential to determining which choice makes more sense for you.
The challenge lies not in determining which account is superior but in understanding how each fits into your retirement strategy.
Roth IRA
Let’s first focus on the Roth IRA and unpack its key features.
Contribution limits
Roth IRAs have annual contribution limits. The total amount you can contribute to all your IRAs in 2024 can’t exceed the lesser of the following:
- $7,000, or $8,000 if you’re 50 or older.
- Your taxable compensation for the year.
Income limits
Roth IRAs also have income limits that determine whether you can make a full contribution, a partial contribution or no contribution.
2024 Roth IRA income limits
Tip: The IRS changes these income and contribution limits regularly. Stay up to date and plan your contributions accordingly.
Tax treatment
As mentioned above, you pay taxes upfront on your Roth IRA contributions. The benefit comes later. Roth IRA earnings grow tax-free, and distributions are tax- and penalty-free provided you are at least 59½ years old and have held the account for five years or more.
Investment options
Roth IRAs generally offer wider ranges of investment options than 401(k)s do. You can invest in stocks, bonds, mutual funds, exchange-traded funds and even real estate, making the Roth IRA an attractive choice if you want more control over your investments.
In conclusion, the Roth IRA is a versatile retirement planning tool whose unique features complement the strengths of a 401(k). But just like in our game of tug of war, understanding the Roth IRA is only half the battle.
401(k)
The 401(k) serves as a potent counterpart to the Roth IRA. Let’s unpack what makes it an attractive retirement vehicle.
Contribution limits
The amount you can contribute to your 401(k) in 2024 is a whopping $23,000, or $30,500 if you’re 50 or older. But that’s not all.
Many employers also offer matching contributions. This means that if you make contributions to your 401(k) plan, your employer will match them, up to a certain amount. The combined limit for employee contributions and employer matching contributions in 2024 is $69,000, or $76,500 if you’re 50 or older.
These limits make the 401(k) a powerful tool for people with the desire and ability to save more for retirement.
Income limits
In contrast to Roth IRAs, 401(k)s do not have income limits. Whether you’re just starting your career or sitting comfortably in a high-income bracket, you can contribute to a 401(k).
Tax treatment
401(k) contributions are made with pretax dollars. They are deducted from your paycheck before taxes are withheld, reducing your taxable income.
Unlike Roth IRA withdrawals, 401(k) withdrawals during retirement aren’t tax-free. Your contributions and earnings are subject to federal and most state income taxes when you take distributions in retirement. This tax treatment makes the 401(k) a great tool for people anticipating a lower tax bracket in retirement.
Investment options
The 401(k) doesn’t offer as much flexibility as the Roth IRA in terms of investment options. Your choices are usually limited to those provided by your employer. This does have the advantage of simplicity. People who prefer a straightforward, curated selection of investments might be less overwhelmed by a 401(k) than an IRA.
There you have it. The 401(k) — with its higher contribution limits, lack of income limits and tax benefits for people who expect to be in a lower tax bracket later in life — is an essential player in your retirement tug of war.
But remember that you can contribute to both a 401(k) and a Roth IRA. The interplay between the two can help lay the foundation for a comfortable retirement.
Key differences between a Roth IRA and 401(k)
We delved deep into the individual characteristics of 401(k)s and Roth IRAs. Now let’s outline some key differences between these retirement heavyweights.
For starters, a 401(k) is an employer-sponsored retirement plan, while anyone with earned income can open a Roth IRA on their own.
Their tax treatment is another distinguishing factor. With a Roth IRA, you make after-tax contributions, your money grows tax-free and you generally can take tax-free distributions in retirement. That’s a pretty sweet deal if you expect to be in a higher tax bracket when you retire.
A 401(k), on the other hand, can help mitigate higher taxes during your peak earning years, said Bill Hines, president and accredited financial counselor at Emancipare Investment Advisors. It does so by operating on a pretax basis. This means the money is deducted from your paycheck and deposited into your retirement account before taxes are withheld, effectively reducing your taxable income for the year. But when it’s time to hang up your work boots and start drawing on your 401(k), you’ll owe income taxes on the distributions.
One more significant difference between 401(k)s and Roth IRAs lies in the income limits. “The Roth IRA has income limits that may inhibit your ability to contribute in a particular year,” Hines said. But you can contribute to a 401(k) regardless of how much money you make.
2024 Roth IRA vs. 401(k) at a glance
The pros and cons of 401(k)s and Roth IRAs can complement one another and help fortify your financial future. Utilizing both is a way to craft a well-rounded retirement strategy. Remember that they are not competitors but teammates working together to secure financial peace of mind.
There isn’t a one-size-fits-all answer to whether investing in a 401(k) or Roth IRA is better. Instead, it depends on your income, tax situation and retirement goals.
A 401(k) may make sense if your employer offers matching contributions or if you are in a higher tax bracket now and expect to be in a lower tax bracket later in life. A Roth IRA could be a good option if you expect your income and tax rate to increase in the future, as it offers tax-free growth and tax-free withdrawals in retirement.
Yes, you can have a 401(k) and a Roth IRA. Using both can be an effective way to diversify your tax exposure in retirement. Just remember that each account has its own set of rules.
Deciding how much to invest in a 401(k) and Roth IRA largely depends on your financial circumstances, retirement goals and tax situation. Many experts recommend you contribute enough to your 401(k) to take advantage of any employer match, as it’s essentially free money.
From there, consider investing in a Roth IRA if you meet the income requirements. The exact amount will depend on your income, age and financial objectives. As always, it’s best to consult a financial advisor to create a retirement strategy that suits your needs.
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