Retirement is a time for freedom and dreams. You may want to buy a classic car or go skydiving. However, you must have enough money to live your dreams after retirement. This is where understanding retirement savings becomes crucial.
When we talk about retirement, we immediately think about retirement tools like Roth IRA and 401(k) retirement. A Roth IRA offers tax-free growth and withdrawals in retirement, while a 401(k) is a company-sponsored plan with tax-deferred contributions.
The question is, which one should you choose; which one is better? Here is a detailed analysis of Roth IRA vs. 401(k).
What is a 401(k)?
A 401(k) is a retirement savings plan that employers usually provide to help employees save for retirement. In this retirement plan, you specify the amount you want to invest from your salary. The amount is deducted automatically from your paycheck into your retirement fund.
What are the Benefits of a 401(K)?
Here are the top benefits of a 401(k).
Increased Contribution Limits
In 2024, the maximum amount employees can invest in 401(k), 403(b) or most of the 457(b) plans is $23000. An additional $7,500 is also allowed for those aged 50 and above.
Reduced Taxable Income
Contributing to a traditional 401(k) lowers your taxable income. It ultimately leads to lower taxes during tax season.
Employer Matching
In 401(k), employers can match your contributions, doubling your investment immediately; a 100% return on investment. However, it is important to not all employers offer the matching as the government doesn’t require it.
Better Portability/Transfer Options
You can transfer your 401(k) to an IRA if you change jobs or if your company shuts down. It ensures your savings stay with you.
Disadvantages of a 401(k)
When considering the advantages of a 401(k), it is also important to know about its shortcomings.
Limited Mutual Fund Options
Companies often hire a third-party admin for their retirement plans. This admin chooses the mutual funds available which reduces the options available for you.
Required Minimum Distributions (RMDs)
At age 72 (or 73 from 2023 onward), you must start withdrawing a specific amount from your 401(k) annually. Failing to do so will result in penalties for you. Withdrawals prior the age of 59 1/2 also incur penalties.
Taxed Retirement Withdrawals
Contributing to a traditional 401(k) gives you tax breaks upfront. However, when you retire, you will pay taxes on withdrawals. It means you can face a hefty tax bill based on your future tax bracket.
Waiting Periods
Lastly, you may also have to wait before joining a 401(k) or receiving an employer match when joining a new company.
What is a Roth IRA?
A Roth IRA is an individual retirement account that you can open independently. It is important to note that a Roth IRA offers tax-free growth for your savings. This means that once you reach 59 1/2, you can withdraw funds from your account without paying any taxes. Let’s have a look at the perks and drawbacks of a Roth IRA.
Benefits of Roth IRA—Roth IRA Advantages
Following are the worth mentioning advantages of a Roth IRA.
Tax-Free Growth
In a Roth IRA, you use money after tax deduction for contributions. This means your savings grow without being taxed. Also, you do not have to pay taxes when you withdraw during retirement.
Independence from Employer Plans
One of the best things about Roth IRA is that you can open a Roth IRA anytime. Your job status doesn’t matter in this regard. You don’t need to transfer or manage multiple 401(k) accounts from previous jobs.
Diverse Investment Options
A Roth IRA offers thousands of mutual funds to choose from. This feature gives you more control and potential for better choices compared to limited options in some retirement plans.
Spousal IRA Option
Even if one spouse does not work, they can have a Roth IRA funded by the working spouse. This flexibility is not available with employer-based plans like 401(k)s, where only the employee can contribute.
No Mandatory Withdrawals
Unlike some other retirement accounts, a Roth IRA does not force you to withdraw money at a certain age. You can let your savings grow for as long as you want.
Drawbacks of Roth IRA
A Roth IRA may seem exciting, but it also has its drawbacks. Here are some of them.
Low Contribution Limits
In 2024, the maximum you can invest in a Roth IRA is $7,000 ($8,000 if you’re 50 or older). It may seem limited when you compare it to the $23,000 limit for 401(k). Thus, making a combination of 401(k)s and Roth IRAs is more beneficial.
The Five-Year Rule
Most people won’t encounter this, but remember, you can’t withdraw from a Roth IRA within five years of opening it. You will have to pay penalties if you do so. Also, early withdrawals before 59 1/2 incur taxes and penalties, just like with a 401(k).
Income Eligibility
High earners might not qualify for a Roth IRA. If your income exceeds $161,000 (single) or $240,000 (married filing jointly), you cannot contribute in 2023.
Roth IRA vs. 401(k)—Head-to-head Comparison
Let’s do a Roth IRA vs. 401(k) comparison.
| Feature | Roth IRA | 401(k) |
| Eligibility | It requires earned income, and there are some income restrictions based on filing status. Spousal Roth IRAs are available for married couples with one income earner. | Available through employer programs with potential waiting periods |
| Maximum Contribution limits | In 2024, the maximum contribution limit is $7,000 per year ($8,000 for age 50+). | 2024 limit: $23,000 per year ($30,500 for age 50+). Additional limits for highly compensated employees may apply. |
| Taxes | Contributions are made with after-tax dollars. It allows tax-free growth and tax-free withdrawals in retirement. | Contributions are made with amounts before tax deduction which reduces taxable income. |
| Investment options | It provides a better range of investment options with greater control. | It is controlled by a third-party administrator, which limits your investment choices. |
| Penalties | There are penalties for withdrawals before age 59 1/2. | Penalties for withdrawals before age 59 1/2. |
How to Make a Combination of a Roth IRA and a 401(K) for Better Output
Simply put, it should not be a Roth IRA vs. 401(k); it must be like Roth IRA and 401(k). Investing in both a 401(k) and a Roth IRA is ideal if you are eligible for both. You can start by maximizing your employer match in the 401(k) because it is free money.
Then, prioritize contributions to a Roth IRA for its tax benefits as withdrawals are tax-free in retirement which ultimately offers long-term advantages.