Taxes & Retirement
Jun 16, 2022
Roth IRA vs. 401(k): Which Is the Better Choice for You?
Should you open an IRA or a 401(k)? We break it down.
Saving for retirement can feel daunting when you’re choosing among different investment options. While you can enjoy tax benefits with many types of retirement accounts, each one has different rules, advantages, and disadvantages. Learn the differences between Roth IRAs vs. 401(k) plans to help you choose the right path for you.
It’s important to remember that the sooner you start funding a retirement account such as an IRA or 401(k), the more money you can potentially save by taking advantage of something called compounding, which is when the returns and interest your accounts earn also earn additional interest and returns.
What is a Roth IRA?
A Roth IRA is a tax-advantaged investment account designed to help people build savings for retirement. Like most retirement accounts, there’s a trade-off: Keep your money tucked away until you reach a certain age, and you can reap tax benefits.
Roth IRAs are funded with post-tax dollars, meaning you invest money you’ve earned and already paid income tax on. You can include most types of securities in your account, like stocks, bonds, mutual funds, and exchange traded funds (ETFs). Once you open a Roth IRA, you can invest additional money over time and make trades, much like you would with any other kind of investment account. And if you follow the withdrawal rules, you won’t pay tax on your earnings.
An important reminder: A Roth IRA isn’t a savings account. It’s an investment account, and all investment comes with risk, including the risk that you could lose money.
Benefits of a Roth IRA
If you’re saving for retirement, Roth IRA might have unique tax benefits for you.
1. You may pay less tax overall
Many people earn less earlier in their careers, and the lower your income, the lower your tax bracket. Over time, your salary may increase, along with your tax rate. Since you don’t pay tax on qualified withdrawals from your Roth IRA, which are generally taken after retirement age, you wind up paying less tax overall on money you invested when you were in a lower tax bracket.
2. Tax-free growth
If your investments earn money, it isn’t taxed while it remains in your Roth IRA. Thus, anything you earn through dividends, interest, and selling shares will grow tax-free. You can also reinvest your earnings to boost your portfolio.
3. Tax-free withdrawals
As a general rule, you must leave your money in the account until age 59½, although there are some exceptions that let you make early withdrawals from your Roth IRA, like a qualifying first-time home purchase. Withdrawals that follow the guidelines are called qualified distributions, and you pay no tax on them. That means the money your investments have earned isn’t taxed at all.
4. No required withdrawals
Money in a Roth IRA can remain in the account as long as you live, unlike traditional IRAs. You can even leave your Roth IRA to your heirs in your will. This can be an advantage if you plan to pass your assets on to others after your death.
Disadvantages of a Roth IRA
Despite their benefits, Roth IRAs come with some drawbacks.
1. Paying taxes up front
Paying income taxes earlier in your career may save you money over the long term. But in the short term, you miss out on the opportunity to reduce your tax burden by contributing pre-tax money, which is offered by traditional IRAs. There’s also no guarantee that your tax bracket will be higher at retirement age than when you contribute.
2. Contribution limits and income limits
As of 2022, Roth IRAs cap annual contributions at $6,000, or $7,000 if you are over 50. And there are income limits that could reduce or even eliminate your allowed contribution. For example, you can’t contribute the full amount if you earn at least:
- $204,000 for married filing jointly or qualifying widow(er)
- $129,000 for single, head of household, or married filing separately if you didn’t live with your spouse during the tax year
- Any income for married filing separately if you lived with your spouse during the tax year
You can use this IRS worksheet to calculate the reduced Roth IRA contribution amount.
In addition, you can’t contribute to a Roth IRA at all if you meet one the criteria below:
- $214,000 for married filing jointly or qualifying widow(er)
- $144,000 for single, head of household, or married filing separately if you didn’t live with your spouse during the tax year
- $10,000 for married filing separately if you lived with your spouse during the tax year
3. Strict withdrawal rules
Most tax-advantaged retirement accounts have exacting withdrawal requirements, and Roth IRAs are no different. You must leave your money in the account for at least five years, and you typically cannot withdraw money before age 59½. If you break the rules, you’ll likely owe taxes as well as early withdrawal penalties.
What is a 401(k)?
A 401(k) is a tax-advantaged retirement plan that an employer offers to its employees, often along with an employer match program. The money in the plan is invested, like the money in a Roth IRA, but the employer decides what options are available.
Benefits of a 401(k)
401(k) plans have many advantages, some of which are not available in other retirement accounts.
1. Employer matching contributions
If you’re comparing a Roth IRA vs. 401(k), employer matching contributions might be an important difference. Typically, employers will match your contributions to the 401(k) plan, up to a certain amount. It’s essentially free money.
The employer match usually comes with a catch: a vesting schedule. That means you gain ownership of the funds the employer contributes only after a certain amount of time, as an incentive to stay with the employer. For example, if your employer has a graduated vesting schedule, you might become vested at a rate of 25% per year, meaning that you’d need to stay with the company for four years to actually get 100% of the funds your employer contributed. Companies can choose whatever vesting schedule they want, but the longest allowed is six years.
2. Pre-tax contributions + tax-deferred growth
401(k) contributions come from your pre-tax wages, which lowers your taxable income. For example, if your monthly salary was $3,000 and you contributed $100 to your 401(k), you would owe tax on $2,900.
Your investment earnings also grow tax-free while your money remains in the account. That said, you must pay taxes on both your contributions and earnings when you withdraw money.
3. High contribution limits
The annual cap on 401(k) contributions is significantly higher than the Roth IRA limit. For 2022:
- Employees can contribute up to $20,500
- Employees over 50 can contribute an extra $6,500
- With the employer match, contributions cannot exceed $61,000, or $67,500 for employees over age 50
Be aware that, like Roth IRAs, 401(k)s have some income limits; your maximum contribution may be reduced if you earn $305,000 or more.
4. Special protections under ERISA
The Employee Retirement Income Security Act of 1974 (ERISA) protects retirement funds in certain investment accounts, including 401(k)s. It sets operational standards, disclosure requirements, and accountability mechanisms, although it is still possible that you could lose money on your investments. It also protects your plan from creditors, even if you or your employer declare bankruptcy.
Disadvantages of a 401(k)
401(k)s come with some drawbacks that may be important to consider.
1. Fewer investment options
Unlike Roth IRAs, which allow you to put your money into an array of securities, 401(k)s usually offer limited investment options. The average plan has 8 to 12 choices; sometimes only mutual funds are available. 401(k) plans may also have limits on how frequently you can change your selections.
2. Potential for higher taxes
As with Roth IRAs, the potential tax benefits of 401(k)s are not guaranteed. While pretax contributions can save you money in the short term, it’s possible you’ll be in a higher tax bracket when you withdraw funds after retirement age, which may ultimately result in you paying higher taxes on your contributions and earnings.
3. Potential for higher fees
Because 401(k)s are highly regulated, they tend to require active management. That can translate to higher fees.
4. Strict withdrawal rules
If you withdraw money from your 401(k) before age 59½ , you’ll likely owe penalties, although you may qualify for a loan from your 401(k) plan in some cases of financial hardship. You also can’t leave your money in the account indefinitely; you must begin making withdrawals by age 72.
Roth IRA vs. 401(k): Key differences
Can you invest in both a 401(k) and a Roth IRA?
So which is right for you: Roth IRA vs. 401(k)? Here’s the great news: you can have both. Even if your employer offers a 401(k), you can open a Roth IRA and contribute up to the maximum allowed for each account. If saving for retirement is a high priority for you, this can be a good way to maximize the amount you can invest.
If your employer offers matching contributions, you may want to contribute enough to get the full match, and then invest in a Roth IRA. If you’re able to fully fund the Roth IRA, you can put any additional deposits into the 401(k), up to the annual limit.
If your employer doesn’t match contributions, consider funding a Roth IRA first and then contributing to your 401(k) once you’ve reached the annual maximum.
When should you not invest in a Roth IRA?
With any tax-advantaged retirement account, you’re trading tax benefits for keeping money in the account until retirement. So if you expect to need your money before you reach retirement age, a Roth IRA may not be the right choice for you. Also, if you expect to be in a lower tax bracket when you retire than you are now, you might save money by paying taxes when you withdraw money, rather than when you contribute it. Finally, if reducing your tax burden now by investing pre-tax dollars is important, a Roth IRA won’t give you that advantage.
How to choose the right one for you
For many people, the employer match is a deciding factor in opting for a 401(k). The funds your employer contributes are part of your total compensation, so you may want to ensure you take advantage of it.
On the other hand, if your employer doesn’t match contributions, you might choose a Roth IRA for the lower fees and wider range of investment options.
Ultimately, you’re likely to enjoy tax benefits when you put your money into either a Roth IRA or 401(k). And when you’re saving for retirement, the sooner you get started, the more time you have for your investments to bear fruit.
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“Retirement Portfolio” is an IRA (Traditional or Roth) and is a non-discretionary managed account. Stash does not monitor whether a customer is eligible for a particular type of IRA, or a tax deduction, or if a reduced contribution limit applies to a customer. These are based on a customer’s individual circumstances. You should consult with a tax advisor.
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