Max out both (if you can) to have a well-funded retirement

Quick Summary

  • Roth IRAs are more tax efficient than 401(k)s.
  • Qualified withdrawals from Roth IRAs are tax-free. 
  • Roth IRAs have more flexibility than 401(k)s in terms of investment choices.
  • If your employee offers a 401(k) match, you should take advantage of that first.

Anyone who has thought about retirement knows there are a lot of ways to save. Roth IRAs and 401(k) retirement savings plans are both popular, but there are several features that make the Roth a better choice for some investors. Here’s a quick rundown.  

A Roth IRA Is More Tax Efficient

A key benefit of a Roth IRA is that you can withdraw your earnings tax-free in retirement. 

When you contribute to a Roth IRA, you do so with after-tax dollars. Because that money has already been taxed, you’re free to withdraw your contributions at any time, and for any reason, without owing taxes or penalties. 

You can start withdrawing your earnings tax-free and penalty-free when you turn 59 ½, provided the account is at least five years old. These tax-free withdrawals are one of the biggest benefits of a Roth IRA compared to a 401(k) retirement plan.

If you expect to be in a lower tax bracket now, and a higher bracket when you retire, a Roth IRA can make the most financial sense. That’s because you’ll pay all your taxes early in the investing process when you’re in a lower tax bracket. In retirement, you can withdraw your contributions and earnings tax-free—even if you’re in the top tax bracket. 

With 401(k) retirement plans, you deduct contributions on your income tax return, which lowers your taxable income. However, when you withdraw the funds later in your career or when you retire, you’ll pay taxes on your contributions and all the earnings. That can be a significant tax bite during retirement when you need your money the most. 

A Roth IRA Is More Flexible

A Roth IRA offers more flexibility than a 401(k) retirement plan. Both types of accounts make wide use of mutual funds. But 401(k) investors are limited to the funds their employers suggest. For example, the federal Thrift Savings Plan, which is the government’s equivalent to a 401(k) retirement plan, offers just five index fund options (plus Lifecycle target-date funds created from these options).

Also, while you can take out a loan against most 401(k) retirement plans, you’re severely penalized if you withdraw your investment from a 401(k) before you turn 59 ½.

If you have a Roth IRA, you can pick your investments as a self-directed Roth IRA. This opens a much wider universe of investment opportunities, including gold and real estate.

And, Roth IRAs provide several opportunities to take early withdrawals of earnings without penalties to pay for qualified exceptions such as a home purchase and educational expenses, if you have a permanent disability, and other specific instances. In addition—because you already paid taxes on it—you can always withdraw the amount you contributed, at any age, for any reason.

If You Get a 401(k) Match, Do that First

There’s one big exception to the benefits advantage of a Roth IRA. If your employer offers a matching contribution, you should first invest enough money to get the maximum match. Many employers match up to 5% of an employee’s contributions, which is essentially a 100% rate of return on that money. Never ignore free money.

Once you’ve met the match, consider investing up to the IRA contribution limit in a Roth IRA, if you qualify for one. And that’s the other key “but”: There is an income limit on who can invest in a Roth IRA. For 2019, if you’re married filing jointly and earn $203,000 or more, you can’t invest in a Roth IRA. For singles, the figure is $137,000. 

Know Your (Contribution) Limits

Of course, you can’t invest an infinite amount of money in either retirement-savings vehicle. For 2019, you can contribute up to $6,000 to a Roth IRA ($7,000 if you’re 50 and over). For 401(k)s, the limit is $19,000 ($25,000 with the 50+ catch-up contribution).  

A good strategy (if you can manage it) is to invest in your 401(k) up to the matching limit, then in a Roth to the contribution limit. Any leftover funds can go toward your 401(k)’s contribution limit. 

In many cases, a Roth IRA can be a better investment choice than a 401(k) retirement plan. A Roth IRA offers a flexible investment vehicle with greater tax benefits—especially if you think you’ll be in a higher tax bracket later on. 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 better choice for your situation.

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