Roth IRA vs 401k

Roth IRA vs. 401k... Which one is best to contribute to?

The answer, of course, depends in great part on which account (perhaps both) is the right fit for your individual financial plan.

Whether you choose to contribute to a Roth IRA, a 401k, or both, you need to ask yourself, "Does my plan feature..."

• Tax Deductible Contributions?
• Tax Deferred Investment Gains?
• A Maximum Income Limit for Contributions?
• Taxation of Withdrawals?
• Early Withdrawal Penalties?
• Required Withdrawals?
• Investment Options?

Each of these factors needs to be taken into consideration when comparing a Roth IRA vs. 401k.

To determine which contribution strategy is best for you, let's examine each factor individually.

Tax Deductible Contributions

In a Roth IRA vs 401k grudge match, the 401k wins the tax deductibility category hands down.

Why?

Well, first off, a 401k is tax deductible while a Roth IRA is not.

What does that mean?

It means you contribute pre-tax dollars to your 401k, thus lowering your overall income tax liability. You might ever lower your taxable income so much that it puts you in a lower income tax bracket... That's even better!

In addition, the advantage a Roth IRA enjoys with tax-free retirement withdrawals (a 401k is subject to income taxes upon withdrawal) is offset by higher contribution limits for a 401k.

Don't follow?

I'll try to explain...

Under IRS rules, a person under 50 years of age can contribute up to $5,000 per year to a Roth IRA. But the same person can contribute up to $16,500 per year to a 401k.

Of course, the annual 401k contribution limit differs from employer to employer. For instance, some employers limit your contribution to no more than 10% of your salary. So unless you earn $165,000 or more, you can't contribute the IRS maximum anyway.

However, assuming you're able to contribute the $16,500 maximum to your 401k, doing so is of greater benefit than contributing the maximum $5,000 to your Roth IRA. After all, even if the 401k is subject to income taxes during your retirement, you're able to save more than triple the amount of money to grow tax-free until retirement.

Okay. So what if you only have $5,000 to contribute?

In most cases, the 401k is still a better deal.

Why?

Because most employers match employee contributions up to a certain percentage or dollar amount. The amount of the match is up to the discretion of the employer, so you'll have to check and see what your own plan states.

So if you pit a 401k versus a Roth IRA, which one is the better deal?

It really depends on the details of your 401k plan...

401k tax deductibility has its merits, but so do tax-free Roth IRA withdrawals in retirement.

As a general rule, if your employer offers matching funds for 401k contributions, you want to contribute at least up until the match. Otherwise, you're leaving free money on the table.

Tax Deferred Investment Gains

A Roth IRA and a 401k both feature tax-deferred investment gains. So, as is the case with a Traditional IRA, neither one has an advantage over the other when it comes to growing your money tax-free...

So what are tax deferred investment gains?

When you invest in a 401k or a Roth IRA, any investment gains (i.e. interest, capital gains, dividends, etc.) are free of taxes.

This allows you to grow investment savings into a much bigger pile than you otherwise could if you owed capital gains and/or income taxes on the same investments.

Tax deferred investment gains are the silver bullet that make contributions to a retirement account such as a 401k, an IRA, or a Roth IRA versus a non-tax sheltered account so much more valuable.

Over the long-term, a tax-free investment portfolio grows to be much larger than a fully-taxable investment portfolio. So make sure you take advantage of your retirement options!

The Maximum Income Limit For Contributions

A Roth IRA vs. a 401k... Which one limits contributions in relation to how much you earn?

If you said the Roth IRA, you're right.

Currently, single individuals earning $120,000 or more and married individuals earning $176,000 or more exceed the IRS income limit for making a Roth IRA contribution.

A 401k?

There are no income limits for a 401k. You can earn as much as you like, and you can still contribute up to the maximum amount.

So the 401k definitely has an advantage over the Roth IRA when it comes to meeting the income requirements for making a contribution.

Taxation of Withdrawals

How about a Roth IRA versus a 401k when it comes to taxing withdrawals during retirement?

When it comes to qualified withdrawals, a Roth IRA beats a 401k without question.

Why?

As we mentioned before, once you make a Roth IRA contribution, you never pay taxes on that contribution or its associated investment gains EVER again.

Assuming you follow all of the rules, waiting at least 5 years and until you reach the age of 59 ½, then your Roth IRA tax liability ends forever the moment you make an after-tax contribution.

You're done paying taxes. Absolutely finished...

Your Roth IRA retirement is now tax-free!

But your 401k?

Nope.

Since you made tax deductible contributions to fund your 401k, retirement is when Uncle Sam comes to get his share.

When it comes time to use your money, 401k withdrawals are subject to income taxes.

So not only do you owe income taxes on your 401k withdrawals, but if income tax rates increase between today and the day of your retirement, you may end up paying more than you anticipate. This is yet another reason why a Roth IRA wins out over a 401k when it comes to withdrawals...

Tax-free means tax-free.

But taxed?

That could mean a lot of things...

Taxed at what? 15%? 25%? 40%? 75%???

Keep this in mind when listing the pros and cons of a 401k versus a Roth IRA...

Early Withdrawal Penalties

Which is better when it comes to early withdrawal penalties? A Roth IRA or a 401k?

There's really no difference.

Neither account has a decisive edge over the other because you incur the same 10% early withdrawal penalty for unqualified withdrawals made prior to age 59 ½. In addition, both are subject to income taxes.

However, if having access to a pool of emergency funds gives you peace of mind, the Roth IRA might be your best bet.

Why?

Because Roth IRA contributions can be withdrawn tax-free and penalty-free.

Notice the key word here... Contributions. You can't withdraw investment gains tax-free and penalty-free.

But under IRS rules, you can withdraw funds equal to your original contribution amount tax-free and penalty-free. After all, since your contribution wasn't tax deductible when you made it, it shouldn't be subject to income taxes a second time...

You might want to take this into consideration when debating the merits of a Roth IRA vs. a 401k.

Required Withdrawals

So how does a Roth IRA stack up versus a 401k when it comes to required withdrawals?

Once again, the Roth IRA wins.

Why?

Because IRS regulations require 401k participants to begin making distributions (withdrawals) at age 70 ½. Roth IRA participants aren't bound by such arbitrary age limits.

And waiting longer to make withdrawals from your retirement account can be a significant advantage.

How?

By allowing you to grow your investment portfolio tax-free for a longer period.

After all, if you don't need your 401k funds at age 70 ½, why should you be forced to withdraw them and pay taxes?

Keep this in mind if you plan to supplement your retirement with rental property, a defined benefit pension, or some other means of income which will allow you to reach age 70 ½ without needing to touch your 401k. If this is your plan, a Roth IRA is most likely the preferable option.

Investment Options

Pitting a 401k versus a Roth IRA, which one offers the widest array of investment options?

Hands down, it's the Roth IRA.

With a Roth IRA, you can invest in almost anything.

But a 401k?

Almost every 401k plan has a limited number of investment options. And these options are usually not chosen by you, but by the plan administrator. Investing in individual stocks is rarely an option.

But with a Roth IRA, you have the flexibility and choice to make your own decisions. You aren't locked into the funds or offerings of your plan administrator.

If you're interested in investing in individual stocks, then a Roth IRA is much better choice than a 401k.

Conclusion

Well, there you have it... The Roth IRA vs. the 401k.

Which one is best?

Again, it depends on your personal financial goals.

However, unlike a Roth IRA vs. a Traditional IRA, you don't need to choose one over the other or divide your maximum contribution between the two. You can choose to fund both to the maximum.

If you're willing and able to do so, I highly recommend it.

However, if you're unable to contribute the maximum to both, make use of our Roth IRA vs. 401k calculator to help prioritize your focus.

Know your options, and take advantage of all the benefits each plan offers...

Lower your taxable income by making a tax deductible 401k contribution and avoid taxes in retirement by fully funding your Roth IRA.

But most importantly, take advantage of both by investing as much tax deferred money as possible in preparation for retirement. Money that grows tax-free for a long period of time ends up being worth a whole lot more than money that's taxed all along the way.

So take advantage of that tax-free growth. Max out your 401k at least to the point at which you get your employer matching funds, and max out your Roth IRA while you're at it.

It may take a bit of financial sacrifice to do so, but you'll thank yourself down the road... with a much higher standard of living in retirement!