Roth IRA vs. 401(k): What’s the Difference?

Roth IRA vs. 401(k): An Overview

Both Roth IRAs and 401(k)s are popular tax-advantaged retirement savings accounts that allow your savings to grow tax free. However, they differ where tax treatment, investment options, and employer contributions are concerned.

Contributions to a 401(k) are made pre-tax, meaning they are deposited before your income taxes are deducted from your paycheck. The amounts are tax deductible, thereby reducing your taxable income. However, in retirement, withdrawals are taxed at your then-current income tax rate.

Conversely, there is no tax deduction for contributions to a Roth IRA. However, the contributions and earnings can be withdrawn tax free when in retirement.

In a perfect scenario, you would use both accounts to put aside funds that can then grow tax deferred for years. However, before deciding on such a move, there are several rules, income limits, and contribution limits you should be aware of.

Roth IRAs

A variation of traditional individual retirement accounts (IRAs), a Roth IRA is set up by an individual at an investment firm. Your employer is not involved.

You control your Roth IRA, and your investment choices aren’t limited in the way that 401(k) plan investment options typically are. This gives Roth IRA holders a greater degree of investment freedom than employees who have 401(k) plans (even though the fees charged for 401(k)s are typically higher).

In contrast to the 401(k), after-tax money is used to fund a Roth IRA. This means that you get no tax deduction in the years that you make contributions. However, your money grows tax free and no income taxes are levied on qualified distributions during retirement.

Roth IRA Contribution Limits

The annual contribution limits are much smaller with Roth IRA accounts than for 401(k)s. For 2023, the maximum annual contribution for a Roth IRA is:

• $6,500 if you're under age 50.
• $7,500 if you are age 50 or older.
  

Roth IRA Income Limits

The Roth IRA limits your contributions based on earned income. In other words, how much you can contribute to a Roth IRA depends, in part, on how much you earned in a year. What's more, the contribution amount allowed can be reduced, or phased out, until it's eliminated, depending on your income and filing status for your taxes (i.e., single or married). The income limits change every year.

2023

Individuals with a tax filing status of single can make a full contribution if their annual income is less than $138,000. Contribution amounts are reduced (phased out) if your income ranges from $138,000 to $153,000. If you earned $153,000 or more, you can't contribute anything to a Roth IRA.

Married couples filing jointly can make full contributions if they make less than $218,000. The income phase-out range is $218,000 up to $228,000.

2022

These are increases from the limits for 2022, which were a reduced amount for those with incomes between $129,000 to $144,00 if you were single, and between $204,000 and $214,000 if you were married filing jointly. If you earned more than these limits in 2022, you couldn't contribute to an Roth.

Roth IRA Withdrawals

You can withdraw your Roth IRA contributions at any time or any age without incurring tax or penalty. Withdrawals on earnings, however, could be subject to income taxes and a 10% penalty, depending on your age and how long you’ve had the account.

Importantly, unlike 401(k)s, Roth IRAs have no required minimum distribution (RMDs) rules. So, during your lifetime, you don't have to take any withdrawals from your account. If you don’t need the money in retirement, you can leave it in the account, where it can continue to grow tax-free for your beneficiaries.

If you do take withdrawals, you can avoid taxes and the penalty if your account is at least five years old and the withdrawal is:

• Made after you turn age 59½
• Taken due to a permanent disability
• Made by your beneficiary or estate after your death
• Used to buy, build, or rebuild your first home (a $10,000-lifetime maximum applies)

If you don’t meet these guidelines, you may be able to avoid the penalty (but not the tax) if a qualified exception applies.

Below is a rundown of the pros and cons of Roth IRAs.

401(k) Plans

Named after section 401(k) of the Internal Revenue Code, a 401(k) is an employer-sponsored retirement plan. To contribute to a 401(k), you designate a portion of each paycheck that should go into the plan. These contributions occur before income taxes are deducted from your paycheck. Contributions are tax deductible.

The investment options among different 401(k) plans can vary tremendously, depending on the plan provider. Typically, plans offer a mix of mutual funds and exchange-traded funds, which contain a basket of securities or stocks.

Nevertheless, no matter which fund (or funds) you choose, no investment gains are taxed by the Internal Revenue Service (IRS) until the funds are withdrawn (whereas Roth IRA withdrawals are not taxed).

Notably, 401(k)s have much higher contribution limits than Roth IRAs do.

401(k) Contribution Limits

The 2023 contribution limits are as follows:

• $22,500 if you’re under age 50 (up from to $20,500 in 2022)
• $30,000, which includes an allowance for a catch-up contribution of an extra $7,500 if you’re age 50 or older. The catch-up contribution increased from $6,500 in 2022, which amounted to a total annual contribution of 27,000

401(k) Employer Match

Overall, 401(k) plans are most beneficial when your employer offers a match. A match means employers contribute additional money to your 401(k) account. The match is usually a percentage of your contribution, up to a certain percentage of your salary.

For example, your employer might match 50% of your contributions, up to 6% of your salary. The employer match doesn’t count toward your contribution limit, but the IRS does cap the total amount that can go into your 401(k) each year (your contributions plus the match).

For 2023 and 2022, the combined contribution limits for a 401(k) are as follows.

2023

• $66,000 in total contributions, including employer match, if you're under age 50
• $73,500 if you're 50 or older, including catch-up contributions
• 100% of your salary

2022

• $61,000 in total contributions if you're under age 50
• $67,500 if you're age 50 or older, including the $6,500 catch-up contribution
• 100% of your salary (if it's less than the dollar limits)
  

401(k) and Taxes

You get a tax break when you contribute to a 401(k). That's because you can deduct your contributions when you file your income tax return. This reduces your taxable income, which can save you money.

You’ll pay taxes after you reach retirement age and begin to make withdrawals from the plan. These withdrawals are called distributions and are subject to income taxes at your then-current tax rate. If you think your income will be higher when you retire, you may want to plan ahead, as all income from your distributions will be taxed.

401(k) Required Minimum Distributions

If you have a 401(k), you have to start taking required minimum distributions (RMDs) at a certain age. Your RMD is the minimum amount that must be withdrawn each year from your 401(k) account when you're in retirement.

In other words, you can't leave all of your money in a 401(k). If you do, you'll incur a 50% tax penalty on the amounts of the RMD that were not withdrawn.

You must begin taking required minimum distributions by April 1 of the year following the year you turn 73 (age 70½ if born before 2020) or the year you retire, whichever is later.

Here’s a quick look at the pros and cons of 401(k) plans.

Key Differences

Here’s a rundown of the differences between Roth IRAs and 401(k)s.

The Bottom Line

In many cases, a Roth IRA can be a better choice than a 401(k) retirement plan, as it offers more investment options and greater tax benefits. It may be especially useful if you think you’ll be in a higher tax bracket later on. However, if your income is too high to contribute to a Roth, your employer offers a match, and you want to stash more money away each year, a 401(k) is hard to beat.

A good strategy (if you can manage it) is to have both a Roth IRA and a 401(k). Invest in your 401(k) up to the matching limit, then fund a Roth up to the contribution limit. After that, any leftover funds can go toward your 401(k)’s contribution limit.

Still, everyone’s financial situation is different, so it pays to do your homework before making any decisions. When in doubt, speak with a qualified financial planner who can answer any questions and help you make the right choice for your situation.