IRAs vs 401(k)s – The basics
To choose between an IRA and a 401(k), you will first need to have a firm understanding of how each retirement plan works.
Individual retirement accounts (IRAs) are tax-efficient plans offered by online brokers. The main purpose of an IRA is that it enables you to invest in the stock market in a tax-efficient way. Just like 401(k)s, IRAs come in two different versions – traditional and roth IRAs. Roth IRAs require you to make investments with after-tax dollars. This means that when you get to the age of retirement, you can make tax-free withdrawals from your Roth IRA. You have already had to pay income taxes on the Roth ira contributions so you don’t pay taxes when you make withdrawals. A Traditional IRA enables you to invest with pre-tax dollars. This allows you to invest larger amounts, as you are not paying income taxes on the invested income. When you retire you pay income tax on the withdrawal. As I will explain in more detail later, both Roth and traditional IRAs come with much lower annual limits than 401(k)s. In the 2023 tax year, you can make up to $6,500 in annual IRA contributions. This is increased to $7,500 if you are aged 50 or above.
Unlike a Roth and traditional IRA, 401(k)s are offered by US employers. Not all US employers offer 401(k)s, so you will need to check before proceeding. Nonetheless, 401(k)s also come with the option of a Roth or traditional plan. The fundamentals in this regard are the same as IRAs. While Roth IRAs are limited to just $6,500 in annual contributions for those under 50, 401(k)s allow up to $22,500. The over 50s get even higher contribution limits, with annual contributions of up to $30,000. The investment options available are determined by your employer. This is usually a selection of index funds but can also include stocks. Not only do 401(k)s supersede IRAs for annual limits, but employers oftentimes will match contributions. This means that for every dollar you invest, your employer will match it by a certain percentage, up to an annual limit. According to a Vanguard report, the average 401(k) employer match in the US is 4.5%. This should always be maxed out where possible, as you are getting ‘free money’ contributed to your retirement savings.
Roth IRAs – What to consider
In this section of my guide, I take a closer look at Roth IRAs.
Roth IRA contribution limits
You can invest up to $6,500 into a Roth IRA each year if you are under 50. Those over 50 can invest an additional $1,000 – bringing the annual contribution limit to $7,500. Considering this is much lower than what’s available with 401(k)s, Roth IRAs may not be suitable for high earners.
Roth IRA withdrawals
If you are aged 59½ or above and you’ve had the Roth IRA for at least five years, you can make withdrawals without paying any penalties. You will also avoid paying tax, as you would have already paid this before each IRA contribution was made. However, if you are under the age of 59½ and wish to make a withdrawal, things can get tricky. In most cases, you will pay an early withdrawal penalty of 10%. This is unless you meet one of a handful of personal circumstances. This includes using the IRA withdrawal for a first-time house downpayment, eligible educational expenses, or if you have a permanent disability. However, the 10% penalty is only applicable to your Roth IRA investment gains and not the actual contributions.
- For example, let’s say you have contributed $10,000 to your Roth IRA.
- The IRA has since grown to $12,000 through investment gains.
- In this scenario, you can withdraw the $10,000 without penalty.
- But the $2,000 may result in a 10% penalty, as discussed above.
Advantages of a Roth IRA
The main advantage of opting for a Roth IRA is that your investments will be able to grow tax-free for as long as the plan is open. This is because you will have already paid the tax before the investment was made. Therefore, when you make eligible withdrawals from your Roth, you will do so on a tax-free basis. Another benefit is that you will have access to a sizable range of investments. This is because Roth IRAs are offered by online brokers. As such, you will be able to invest in stocks, ETFs, index funds, mutual funds, bonds, and more. Roth IRAs are also a lot more flexible than 401(k)s, as you can buy and sell investments at any time. In comparison, 401(k)s are structured in line with weekly/monthly payroll.
Disadvantages of a Roth IRA
One of the main disadvantages of Roth IRAs is that annual limits are capped to just $6,500, or $7,500 if you are over 50. Moreover, you won’t be able to make tax deductions on contributions made to a Roth. This is because you can only invest after paying tax on the taxable income. Another drawback is that unlike 401(k)s, you won’t get the tax benefits from employer matching contributions.
Roth 401(k)s – What to consider
In this section of my guide, I will discuss the fundamentals of Roth 401(k)s.
Roth 401(k) contribution limits
Roth 401(k)s enable you to contribute up to $22,500 in the 2023 tax year. If you’re over 50, this is increased to $30,000. Additionally, if your employer offers a contribution match, this is not included in the annual limit. For example, if you invest the full $22,500 and your employer adds a 5% match ($1,125), this will take your annual total to $23,625
Roth 401(k) withdrawals
Withdrawals from a Roth 401(k) are even more restrictive when compared to IRAs. In the vast majority of cases, you will pay a 10% penalty if you are below the age of 59½. This is on both investment gains and contributions. There are certain circumstances that will permit an early withdrawal without paying a penalty. From 2024 onwards, for example, up to $1,000 can be withdrawn from a Roth 401(k) for emergency expenses. Other circumstances linked to domestic abuse and natural disasters may also avoid the 10% penalty.
401(k) required minimum distributions
401(k) plans come with required minimum distributions (RMD). Put simply, this means that you will need to withdraw a certain amount from your 401(k) each year once you turn 73. If you don’t, you may face a penalty of 25% (reduced from 25% in 2023) on the amount that should have been withdrawn.
- For example, let’s suppose that your annual required minimum distributions amounts to $7,000
- You only withdraw $5,000 during the current tax year
- This means that you will penalized on the balance of $2,000
- At 25%, you will lose $500 from your 401(k)
As such, the required minimum distributions should be taken seriously if you are approaching your 73rd birthday. It’s best to speak with a qualified advisor in this regard, as you might be able to switch your 401(k) to a more RMD-friendly IRA.
Advantages of a Roth 401(k)
The main advantage of a Roth 401(k) is that after the age of 59 ½, you will be able to make withdrawals without paying tax. As noted, this is because the tax was paid before you made your contributions (e.g. through payroll). Furthermore, if your employer offers a Roth 401(k) matching program, then this should be taken full advantage of. Not only does this translate to free money, but the contributions made by your employer will continue to give tax free growth.
Disadvantages of a Roth 401(k)
The main drawbacks of a Roth 401(k) are associated with withdrawals. First and foremost, you will find it difficult to avoid paying a 10% penalty on both your contributions and earnings, should you make withdrawals before the age of 59 ½. This means that you should only invest in a Roth 401(k) if you are confident you won’t need the money for short-term expenses. Second, you will also need to take the RMD into account. This will penalize your retirement savings if you are over the age of 73 and you do not withdraw your full RMD.
Is it better to invest in a Roth IRA or 401k?
When making a Roth IRA vs 401(k) comparison, a variety of factors needs to be taken into account, such as:
Put simply, if your employer offers 401(k) matching contributions, then this should be your first port of call. As I noted earlier, this constitutes free money that will be added to your 401(k) plan tax-free. For example:
- Let’s say that you were to contribute $10,000 to your Roth 401(k) this year
- Your employer offers a 4.5% match
- This means that your employer contributes an additional $450
- This takes your total annual 401(k) contribution to $10,450
Over the course of many years, an additional $450 can compound into many thousands of dollars. And, of course, you will also be adding more to the 401(k) as each year passes. This is why a 401(k) is almost always the best option over a Roth IRA – if a matching program is offered by your employer.
Employers generally offer a very limited range of investment options when setting up a Roth 401(k). As such, you won’t be able to invest in an asset if it isn’t supported by your employer. Most Roth 401(k)s support a selection of index funds like the S&P 500. This means that you will gain exposure to the broader US economy. If you work for a company that is publicly listed, you will likely be able to invest in its stock too. However, if the investment options provided by your 401(k) are too restrictive, then you might need to consider a Roth IRA. In doing so, you will likely have access to thousands of assets, from individual stocks and index funds to bonds and even crypto.
You will also need to assess how much money you plan to add toward your retirement account each year. For example, Roth IRAs only permit up to $6,500 annually if you are under the age of 50. If you are looking to invest more than this, then a 401(k) allows up to $22,500. Moreover, if you are aged 50 or above, then you will have access to higher ‘catch-up’ contributions with a 401(k). In fact, you can contribute an additional $7,500 each year with a 401(k), compared to just $1,000 with an IRA.
Another metric to consider when choosing a retirement account is your current income.
- The reason for this is that you can only invest in a Roth IRA if your 2023 income is below $153,000, or 228,000 if you file jointly with your partner.
- Furthermore, if your income is between $138,000 and $153,000, or $218,000 and $228,000 if you file jointly, then your IRA contribution limits will be reduced.
Taxable Income limits are not applied when opting for a traditional IRA or a Roth 401(k).
Access to Financing
While taking out a loan against your retirement savings should be a last resort, this is an option with a Roth 401(k) but not an IRA. This will enable you to raise capital against your contributions as opposed to paying an early withdrawal penalty. This is the case as long as the loan is repaid within five years.
Should I have a Roth IRA and a 401k?
Depending on your financial circumstances, it could make sense to have both a Roth IRA and a 401(k).
This will be the case if you are likely to exceed your annual income limits from one of your retirement plans. Additionally, switching your investments from a 401(k) to an IRA can be logical once your have maxed out your employer’s matched contributions. For example:
- Let’s suppose that you opt for a Roth 401(k) with your employer, which offers matching contributions of 6% up to a maximum of $675 annually
- To take full advantage, you contribute $11,250
- In turn, your employer matches this by 6%, or $675
- At this stage, you decide to make the remaining annual contributions to your Roth IRA – enabling you to invest in a much wider range of markets
Crucially, annual contribution limits need to be taken into account when operating both a Roth IRA and a 401(k). For example, if you prefer a Roth IRA for the sheer number of investment products available, it makes sense to switch to a 401(k) after you have hit the annual limit of $6,500.
In summary, both Roth IRAs and 401(k)s enable you to save for your retirement years in a tax-efficient way. But overall, 401(k)s should typically be prioritized over a Roth IRA. In addition to much higher annual limits, you might benefit from an employer-backed matching program. Ultimately, whether an IRA and/or a 401(k) is suitable will depend on your personal circumstances, so you should seek advice from a qualified advisor.
Roth IRAs vs 401(k) FAQs
At what age does a Roth IRA make sense?
If you have already reached the age of 59 ½ and you still plan to make contributions, then switching to a Roth IRA can make sense. This is because, after holding the account for at least five years, all future withdrawals will be both tax-free and penalty-free.
What are the tax advantages of Roth IRAs and 401(k)s?
When you opt for either a Roth 401(k) or IRA, you will make contributions with after-tax dollars. As such, when you make withdrawals at the age of retirement, you will not pay any tax.