401(k) vs Roth IRA | Definition, Differences, and How to Invest (2024)

What Is a Roth IRA?

Roth IRA is an individual retirement account that allows you to save for retirement without paying taxes now.

You can withdraw your contributions (not the earnings) at any time, tax-free and penalty-free.

Many employers will sign you up for a Roth IRA automatically if they offer it as an employee benefit, however, there are other ways to set up a Roth IRA.

You can contact many banks or investment companies to help you open up your account by sending in the necessary forms.

Deciding between a 401(k) Plan and a Roth IRA? Click here.

What Is 401(k)?

401(k) is a retirement savings plan offered by an employer, which allows employees to contribute a portion of their salary on a pre-tax basis.

Any money contributed (and earnings) is allowed to grow tax-deferred until withdrawal.

401(k) plans are subject to annual contribution limits, which vary according to your age and whether or not you set up a 401(k).

The Difference Between Roth IRA and 401(k)

Both investments allow tax-free growth, however, 401(k) contributions are made on a pre-tax basis, while Roth IRA contributions are made with after-tax dollars. So, you will get it back plus the earnings when you withdraw your money.

Also, 401(k)s are established through employers and can only be funded by salary deferrals (i.e., deductions from your paycheck), whereas Roth IRA contributions can be made through individuals without any income limit or restrictions on how much they contribute.

How to Invest in Either Account

Investing in both accounts is also very different: 401(k) contributions are made through payroll deductions, whereas Roth IRA contributions can be made directly to the investment account by check or electronic funds transfer.

When you want to withdraw your money from your Roth IRA, there are no penalties or tax consequences, but you'll still have to pay income taxes on the amount withdrawn.

On the other hand, when you want to withdraw your money from your 401(k), there are penalties and you will have to pay taxes.

Considerations When Deciding on a Roth or 401(k)

Your Current Income Status

If your annual salary is less than $107,000 (married filing jointly) or $72,000 (single), then you should probably choose a Roth IRA.

On the other hand, if your annual salary is higher than either of those values, you might lean towards a 401(k) because contributions will be taxed when withdrawn and only up to $17,500 (or $23,000 if age 50+) can be contributed to a Roth IRA.

How Soon Do You Need the Money

If you are expecting to use your money in the next five years, opt for a Roth IRA because you won't have to pay any taxes when withdrawing the earnings.

However, if it's going to be 5+ years before you will need to withdraw your money and you're in a high tax bracket now and expect to be in a lower one in retirement, then you should probably keep your money in a 401(k) so you can take advantage of the tax deduction.

The Difference in Tax Rates Between Your Current Income Bracket and the One You Expect When You Retire

If your tax bracket will be the same or higher in retirement, then a Roth IRA might be a good option because withdrawals are not taxed.

On the other hand, if it will be lower, you should choose a 401(k) because contributions come from pre-tax dollars, and only up to $17,500 (or $23,000 if age 50+) can be contributed to a Roth IRA.

Whether or Not You Want to Withdraw Roth IRA Contributions or Earnings

The most important factor in your decision should be how much money you are able to contribute to each account because this will determine how soon you can retire.

Since the limit for Roth IRA is lower than that for a 401(k), if you have the choice of contributing to one or the other, it is usually better to contribute to a Roth IRA because you will not get an immediate tax break and your money can grow without paying taxes.

Whether or Not Your Employer Offers Matching Contributions

If your employer does offer matching contributions, then you should strongly consider choosing a 401(k) because it is free money and you will miss out on that if you choose the Roth IRA.

Which Investments Are Available to You

If one type of investment is not offered by your employer and is available through the other, then the better option for you would be to contribute to the account that offers that investment.

Whether or Not Your Income Makes You Eligible for a Deductible IRA

Even though Roth IRA has a lower contribution limit than the deductible IRA if you are in a higher tax bracket now compared to what you expect your retirement tax bracket to be, then go with Roth IRA because withdrawals will be tax-free.

If it's vice versa, then a deductible IRA might be the better option for you.

How Much Do You Value the Safety of Your Investments Over Their Return

If you are risk-averse, choose a Roth IRA because it offers more safety than a 401(k).

How Soon Do You Plan On Retiring

If your goal is to retire earlier, then the Roth IRA might be a better choice for you because it has a lower contribution limit.

On the other hand, if you want to retire later and will need every penny in your retirement fund, then go with a 401(k) because money can grow faster as well as be tax-free.

Now that you know the factors to consider when choosing between a Roth IRA and 401(k), hopefully, it will be easier for you to make an informed decision about which one is right for you.

The Bottom Line

The Roth IRA and 401(k) are both great options for retirement saving, but you should choose the one that best fits your financial situation.

If you have to contribute to only one type of account, then it's usually better to contribute to a Roth IRA if your income is too high for deductible IRA or if your employer does not offer matching contributions.

However, if both types of accounts are available to you and your employer offers matching contributions, then contribute to the 401(k) because it will receive free money from your employer.

While the Roth IRA might be better for diversification purposes or have lower fees associated with it, don't choose an investment just because it has a lower fee associated with it.

Make sure the investment is available through the account you will be contributing to and that you are choosing between Roth IRA and 401(k) because they offer different investments rather than just lower fees.

Also, when possible, contribute to both accounts since this will allow your money to grow without having to pay taxes on it.