A big decision, such as choosing the best retirement savings plan, should not be taken lightly. It takes a lot of hard work to be able to save for retirement. By the time employees reach retirement age, they need to be able to look forward to living comfortably off their 401(k) or Roth IRA.
That is why it is important to understand, early on, the key differences between Roth IRA and 401 (k) accounts. This knowledge may be pivotal in how individuals spend their retirement days.
While both overlap in many areas, because they aim to provide the same type of services, they do have fundamental differences. It is these differences that we will take a closer look at.
This article will review each retirement savings portfolio separately, looking at the important features of each option. By the time they reach the end, readers will be armed with the required knowledge needed to decide to which retirement savings account they will entrust their future.
Table of Contents
A Retirement Savings Account Overview
One of the most important features that are common in both a Roth IRA retirement account and a 401(k), is that they both allow funds to grow tax-free. It is such tax benefits that make these the most popular investment options among employees.
Where they differ is when it comes to tax treatment, employer contributions, and the variety of investment options available to account holders.
In a 401(k), all contributions are made tax-free, or they can be made from the after-tax dollars, in which all taxes will be deferred until the individual wishes to withdraw money from the account. These deferred taxes will be calculated according to the income tax rates of that time.
A Roth IRA, on the other hand, works in more or less the opposite way when it comes to tax benefits. All Roth IRA contributions are made without any tax break and are charged according to the rate for income taxes at that time. It is the distributions that are tax-free, with individuals being allowed to withdraw money free from their Roth IRA, as long as they are over 59 and 1/2 years old, and the funds have been in the account for more than five years.
The fact that these two types of retirement savings options are both beneficial, while being opposites in many ways, means that having both a Roth IRA and a 401(k) would be the best way to enjoy the best of both worlds. This would mean such individuals will be able to choose which account to make withdrawals from to take full advantage of the above features.
What Are Income Limits?
Income limits refer to the cap that is placed by the IRS on the total amount of money an individual can contribute to their 401(k) or Roth IRA. This rule affects mostly the high-income earners who will be unable to invest as much as they want into their retirement accounts.
In a 401(k), the government places a limit on both the employee and the employer’s contribution. It is because of such limits that individuals who earn a high salary are forced to find other means to fully invest their earnings.
Even though a person is allowed to open as many individual retirement accounts as they wish, the total contributions should still not exceed the annual limit set by the IRS. This leaves one option, which is to invest in a retirement account that has no contribution limits, such as:
Roth 401(k)
If the individual decides to opt for this type of account, then they should expect to be taxed on their contributions in much the same way as a Roth IRA.
The difference between these two is that the Roth 401(k) is still an employer-sponsored program that is tailor suited to high earners, while in a Roth IRA, individuals make all the contributions themselves.
A Roth IRA also has contribution limits, while the other version does not. This is why a such an account is not a suitable option for most employees, and in most cases, only young individuals who fall under a higher tax bracket tend to go for this type of investment.
Contribution Limits
Both a Roth IRA and a 401(k) have to adhere to contribution limits, but in the case of a 401(k), the rules also apply to the employer. This is because the employee can have the employer match their contributions if they can meet the minimum 6% contribution target.
Are Account Holders Expected To Pay Taxes?
Income taxes will always be necessary, regardless of which retirement account options an individual chooses. While both Roth IRA and 401(k) are favored by most people because of their tax benefits, they are not entirely tax-free money.
A certain percentage of a worker’s salary will always be regarded as taxable income. The amount that remains after individuals pay taxes is where the funds for the 401(k) and Roth IRA contributions come from.
What differs between these two options is where the individual chooses to take advantage of their tax break, i.e. either when they make their contributions, or during one of the required minimum distributions (RMDS).
Taxes on Contributions
In a Roth IRA, taxes are charged right at the beginning, when an individual decides to contribute funds to their account. These after-tax contributions can take their toll on a person’s budget and such a retirement account should only be considered after consulting a financial advisor.
Taxes on contributions are charged according to the current rate at the time the individual uses to make contributions. The good thing about a Roth IRA is that after paying taxes on contributions, the rest of the required minimum distributions will be tax-free money, provided the individual meets certain conditions.
Taxes on Distributions
The opposite is true in a 401(k), where after deductions have been made on the taxable income, the individual can fund their retirement savings account tax-free. However, the account does not guarantee completely tax-free money. The only time they will be expected to pay taxes is when they withdraw money from the account whenever they need it, or due to the required minimum distributions.
Individuals also do not pay taxes on any gains, interest, or dividends the plan produces, This is why 401(k) is said to be tax-deferred, and it is not only a way to save for retirement but also a good choice when it comes to reducing the tax costs.
Types of IRAs
While the 401(k) is rather limited when it comes to investment options for employees, IRAs offer many other options besides Roth IRA.
- Roth IRA
A Roth IRA offers tax-free growth on invested funds which is one of the things that attract a lot of individuals. As far as getting a tax break is concerned, it does not get much better than a Roth IRA.
The major requirement of these retirement plans is that funds have to be kept untouched in the Roth IRA account for at least 5 years and that the age of the account holder is 59 and 1/2 years or more before any tax benefit can be applied.
- Traditional IRA
In a traditional IRA, individuals contribute funds, before any tax deduction, towards a retirement savings account, where they can grow until withdrawal. In some ways similar to a 401(k), a traditional IRA is regarded as being based on a tax-deferred investment growth system.
- SEP IRA and simple IRA
These two types of retirement planning are usually used by small businesses with a workforce of less than 100, or by employees whose income limit does not make having a regular 401(k) feasible.
In a SEP IRA, employer contributions can be added to traditional IRA contributions, similar to how 401(k) accounts function. In this case, instead of an employer match system, the employer may contribute as much as 25% of the salary towards the employee’s IRA account.
A SIMPLE IRA, on the other hand, allows an employer to pledge a matching contribution of up to 3% of the employee contributions. The other option available to employers in this type of savings account is to offer a 2% contribution of each employee’s salary.
Early Withdrawals In a Retirement Account
One thing that can cost a lot of money is choosing to conduct early withdrawals in retirement accounts. In fact, the cost can be so much, that in some cases, if there is an option to take out a loan it is much better to choose that one rather than an early withdrawal.
By definition, when it comes to 401(k) accounts and Roth IRAs, an early withdrawal is any money that is taken out of the account before the individual reaches the age of 59 and 1/2 years old.
In a Roth IRA, there is a further stipulation that the funds have to be kept in the account for at least five years before they can be withdrawn.
Failure to adhere to these conditions will result in penalties being issued against the account holder each time they withdraw funds.
Both Roth IRA and 401(k) accounts carry the same penalty, which is 10% of the withdrawal amount, on top of any other payable taxes.
What 401(K) Plans Are All About
By far, the most popular means of saving for retirement is by investing in a 401(k) account. This is because, of all the other savings account types, the 401(k) is the most accessible for employees who earn lower salaries due.
In most cases this type of retirement plan may not be suitable for higher tax bracket earners, so each individual has to carefully assess their particular circumstances.
One way to check if this might be a good option is to calculate an individual’s modified adjusted gross income, in much the same way as the IRS does when determining if one is eligible for certain deductions.
A 401(k) can be defined as a tax-deferred retirement savings account that is offered to individuals by their employers. It can be funded directly from the employee’s salary, with or without additional contributions through an employer match.
401(K) Contribution Limits
The benefits that are associated with having a 401(k) plan can only be fully enjoyed if the employee can meet the stipulated contribution limits. 401(k) accounts usually have much higher contribution limits than Roth IRA.
These contribution limits change from year to year, and in 2021 this is what 401(k) investors were contributing:
- $19,500 for individuals under age 50 (this is now $20,500 in 2022)
- $26,000, for anyone above 50 who qualifies for catch-up contributions of an extra $6,500 if you’re age 50 or older (which is now $27,000 as of 2022)
How Much Does an Employer Match on a 401(K) Plan?
If an employee manages to contribute at least 6% of their salary towards their retirement plan, then in some cases they may receive an employer match contribution onto their 401(k) account.
Usually, an employer match will be 50% of the employee’s contribution, up to a certain percentage limit. This added amount from the employer does not affect the individual’s contribution limits, but the IRS does put a certain limit on the total amount of contributions that can be made by both parties.
Changes in Contribution Limits (2021-2022)
The following are the combined contribution limits allowed by the IRS for a regular 401(k):
- $58,000 for individuals under age 50 ($61,000 in 2022)
- $64,500 for those aged 50 or older, which includes the $6,500 catch-up contribution ($67,500 in 2022)
- If the salary is less than the dollar limit, then contributions from the employer match can be 100% of the income in 2021 and 2022.
401(K) Account Fees
While the 401(k) option has plenty of obvious benefits regarding paying taxes, there is the issue of account fees to be considered. Many retirement plan providers charge annual fees which are usually less than 1% of the employer-sponsored plan.
Apart from that, there are other fees charged for the maintenance of the 401(k) account, which is normally between 0.5% and 2% of the value of the plan. Various factors determine to actual account fees for a 401(k) account, such as:
- The total value of the retirement account
- The number of people on the plan
- Different 401(k) account providers have different fees
Required Minimum Distributions on a 401(K)
In the same way that income limits can force other people to consider other options, the issue of required minimum distributions needs to be carefully considered. This is the amount of money every account holder is required to withdraw annually from their 401(k) account.
From the day the individual turns 72, they are required to withdraw funds annually, starting from the 1st of April the following year. Failure to withdraw funds will result in a strict penalty that can be as high as 50% of the amount that was supposed to have been withdrawn.
The Pros and Cons of a 401(K)
As a brief summary, the pros and cons of having a 401(k) are:
Pros
- Employer match significantly improves the size of the account
- Higher contribution limits than Roth IRA
- Maintained by both employee and employer
Cons
- Very few investment options other than allowing funds to grow tax-free
- Has strict RMDS rules
- Higher fees compared to other retirement options
A Detailed Look at Roth IRA Plans
Sometimes, a good alternative to the 401(k) option may be needed in which case investing in Roth IRAs may be the wisest choice.
People, who end up choosing a Roth IRA as one of their investment options, usually do so for the following reasons:
- Age
Younger individuals are usually encouraged by a financial advisor to go for a Roth IRA individual retirement account, especially if they have a high enough salary that the issue of being taxed when contributing to the account even after the removal of taxable income is not a problem.
Such individuals will benefit from the wider range of investments that can be made through a Roth IRA, and if they want to take advantage of having a 401(k) as well, they can do that.
- Investment Options
Compared to a 401(k) which allows very few options except to wait as the money grows tax-free, Roth IRAs allow investors to be more creative about how they spread out their retirement funds among different portfolios.
- Hedge Against Inflation
Out of the many investment options that Roth IRAs provide, choosing wisely on what to invest in might be able to provide a hedge against inflation. These days, a lot of people are looking into real estate and precious metals as viable ways to save money.
- Self Employed
Without a regular job, self-employed individuals cannot hope to benefit from the employer match system. Without this incentive, choosing a Roth IRA will be a very good option, given the specific benefits regarding tax-free contributions it has.
Roth IRA Income Limits
Income limits for Roth IRAs are tailored to suit the individual based on IRS calculations made using the modified adjusted gross income system. Depending on the results of this calculation, the allowed contribution limit can be reduced or eliminated entirely.
The following are some of the major considerations made:
- Age
Individuals older than 50 years are allowed a catch-up contribution limit, which means they can contribute to a Roth IRA in larger amounts to make up for the time lost.
- Marital Status
Single filers are allowed to make full Roth IRA contributions as long as their salary is less than $125,000. Anything more than that, up to $140,000 is considered to be in the phase-out range.
On the other hand, married couples filing jointly can make full Roth IRA contributions if their combined income is less than $198,000. The phase-out range is considered to be between $198,000 and $208,000.
- Earned Income
High-income earners are excluded from opening a Roth IRA account. Other options are available to them though, such as investing in a Roth 401(k), which has no salary cap.
Roth IRA Withdrawals
When it comes to making withdrawals from a Roth IRA, there is a distinction made between contributions and earnings.
Regarding contributions, there are no stipulations or penalties that can prevent an individual from withdrawing money whenever they want, which is a great way to invest while at the same time having disposable income ready for use should the need arise.
However, there are certain rules and regulations put in place that state that earnings should be kept in the Roth IRA account for at least five years before they can be withdrawn. The individual also needs to be at least 59 and 1/2 years old before they are eligible to withdraw funds without any penalties.
Early withdrawal of earnings will attract a stiff 10% penalty on the value of the withdrawal.
Funding a Roth IRA Account
One of the most popular ways of funding an IRA is by doing a rollover of funds from an existing 401(k) account. The reason for this is that out of the many ways investors can choose to contribute to a Roth IRA, a 401(k) rollover is the easiest to get approved by the IRS.
In just a few days, the money from the 401(k) account can be reflected in the newly opened Roth IRA. Many IRA custodians prefer this method for most of the accounts in their care.
There is also the added advantage that by rolling over money from their 401(k) account, individuals can bypass certain disadvantages, such as the required minimum distributions (RMDS), which effectively means that the formerly tax-deferred funds on a 401(k) are now tax-free money in a Roth IRA.
Pros and Cons of Roth IRAs
Roth IRA has regularly proven to be a great option for a good retirement account, but they do have their downsides as well. The following are the pros and cons associated with having a Roth IRA:
Pros
- All withdrawals are tax-free in retirement after a five-year hold on funds
- More investment choices compared to 401(k)
- No RMDs at any time, as long as the five-year waiting period is kept.
Cons
- Lower contribution limits compared to 401(k)
- Roth IRA income limits exclude high-salary earners
- No employer assistance when it comes to contributing to the account and managing it
Roth IRA or 401(K): The Key Differences To Remember
While the similarities and advantages of owning either a 401(k) or a Roth IRA are many, here are the summarized breakdown of the key areas in which these two account types differ:
- Tax Break
This comes upfront for a 401(k), where individuals are allowed to contribute to the account without paying any taxes, whereas in a Roth IRA, the break comes for all withdrawals made after retirement.
- Withdrawals in Retirement
In a 401(k), withdrawals in retirement are considered taxable income and are charged according to the current rate for income taxes, while for Roth IRAs, all withdrawals after the retirement age are not taxed.
- Employer Match
The big difference between a 401(k) and a Roth IRA is that the first account type is an employer-sponsored retirement plan, meaning a large part of the contributions in a 401(k) come from the employer.
In a Roth IRA, the burden of all the contributions lies with the individual, meaning it can be quite expensive to start and maintain over a prolonged period.
- Income Limits
A 401(k) has higher income limits, which allows both the employer and employee to contribute significant sums into the account every year.
On the other hand, a Roth IRA has very restrictive income limits which make it difficult for high earners to invest in it.
- RMDS
At no point will an investor be asked to withdraw from their Roth IRA without wishing to. However, that is not the case with a 401(k), where individuals have to contend with meeting required minimum distribution demands.
- Average Fees
Average fees for maintaining an individual retirement account are much higher for 401(k) accounts than for Roth IRAs. However, for both account types, these charges are not significantly high and can be easily paid by the interest gained.
- Investment Options
The investment options for funds kept in a 401(k) are very limited. By investing in Roth IRAs, individuals get access to many more investment options, such as stocks, securities, and bonds.
- Employer Assistance
While a 401(k) is an employer-sponsored retirement plan, Roth IRAs are not, meaning everything, from making contributions to maintaining the account fall on the employee’s shoulders.
They will also need to look for the right custodian, which can be tricky for individuals who have never had a Roth IRA before.
Final Words
There are many fundamental differences between a Roth IRA and a 401(k) that individuals need to be aware of before committing to either option. Making the wrong choices may lead to huge losses over the years or regularly suffering from IRS penalties.
Empowered with the knowledge in this article, readers can now make the best decision that will suit their needs and their income bracket. There is no right or wrong choice between a Roth IRA and a 401(k) because both a wide range of tax benefits as well as added security for long-term investing of income for retirement.
Related Pages of Interest
About Tim Schmidt
Tim Schmidt is an Entrepreneur who has covered retirement investing since 2012. He started IRA Investing to share his expertise in using his Self-Directed IRA for alternative investments. His views on retirement investing have been highlighted in USA Today, Business Insider, Tech Times, and more. He invested with Goldco.
