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401(k) and Roth IRA are two types of retirement savings accounts that allow US citizens to save money while protecting some of their savings from tax deductions.
Contributing regularly to a retirement fund is essential to saving up a nest egg for when you can no longer work. Still, the various details of the different programs can be a bit confusing at times.
Roth IRA and 401(k) accounts are both good investments. The one that best suits you depends on your income level and employment benefits. If your income isn’t high, the Roth IRA may be better for you. If possible, max out your Roth IRA and 401 (k) to help you get the most of your savings.
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Should I Go With a Roth IRA or a 401(k)?
You should go with a Roth IRA and a 401(k) whenever you can. It's best to max out both a Roth IRA and a 401(k) to maximize your savings. But if your income is lower and your employer doesn't offer a 401 (k), then a Roth IRA is probably your best bet.
The contribution limits on a 401(k) are much higher, and a good employer will have a program to match your contributions up to a certain percentage. That makes the 401(k) a no-brainer for people with a stable job at a good company.
No matter your situation, it's a good idea to try and max out your Roth IRA since you'll be able to withdraw the funds tax-free once you retire. However, the contribution limits are much lower, and the tax incentives are less juicy compared to a 401(k).
What is a 401(k)?
A 401(k) is a retirement plan sponsored by your employer. When you work for an employer that offers 401(k), a portion of every paycheck you earn will be deposited into the plan.
Some employers offer a matched contribution to incentivize employees to work for them. These contributions are calculated before taxes are deducted from your pay.
There are various options for investing the money contributed to a 401(k), which varies based on the plans offered by your employer.
Most employers don’t offer plans that allow investment in specific companies; it's more common for 401(k) plans to offer mutual funds or ETFs instead.
The IRS doesn’t tax any gains made on your investments in a 401(k).
401(k) Contribution Limits Are Based on Your Age
Like most retirement plans, there’s a contribution limit on how much you can put in every year. These limits are based on how old the account holder is and increase as you get older.
Although matched contributions from your employer are not counted toward your limits, there is an overall contribution limit that includes the employer contributions.
According to Investopedia, in 2021, the contribution limit for individuals under 50 years of age is $19,500. If you're 60 years of age or older, the limit increases to $26,000.
In addition, individuals over 60 can contribute an extra $6,500 in 2021. These limits mean older people will have a chance to catch up if they haven't contributed as much in previous years.
In addition to the individual contribution limits, there are total contribution limits that include the matched contributions from your employer. These are as follows:
2023 401(k) Contribution Limits
- $61,000 total contributions for individuals under 50 years of age.
- $67,500 for individuals over 50 years of age (once again, including the additional $6,500 contribution.
- Once again, if your salary is less than these limits, then you can only contribute up to 100% of your salary.
There’s a Minimum Withdrawal Amount for Your 401(k)
According to The Motley Fool, withdrawals from a 401(k) account are not taxed by the IRS. However, once you've reached retirement, there's a minimum withdrawal amount (a required minimum distribution, or RMD).
That means if you leave all of your money in your 401(k), it will be subject to a 50% penalty on the required minimum that should have been withdrawn.
There are also RMDs for 401(k)s that are inherited by next of kin. These rules differ depending on if you are the spouse or other benefactor of the deceased.
What is a Roth IRA?
A Roth IRA is an individual retirement account offered by an investment firm. The individual sets up and controls the account, allowing for greater freedom in your investments than a 401(k).
However, since the account is established directly between the individual and the investment firm, there is no employer involvement and no matched contributions.
The contribution limits on a Roth IRA are also much lower than a 401(k). Another major difference is that Roth IRA contributions are made after deducting taxes.
Accordingly, unlike with a 401(k), you cannot write off your contributions as tax deductions. As long as the funds remain in the account, the money you earn on your investments is not taxed.
Roth IRA Has Lower Contribution Limits Than 401(k)
Like with a 401(k), Roth IRAs also have contribution limits. These limits are significantly lower than those imposed on a 401(k):
- $6,000 for individuals under the age of 50.
- $7,000 for individuals aged 50 or older, including a $7,000 'catch-up' contribution.
There are also provisions for married couples who file their taxes together. This is an excellent way to increase your contribution limits if you are married.
Withdrawals From a Roth IRA Are Always Tax-Free
Withdrawing your contribution amounts from a Roth IRA is always tax-free, regardless of age. However, withdrawing any financial gains made on the account is subject to penalties depending on your age and the time the funds have been in the account.
Generally, withdrawal of Roth IRA earnings is subject to a 10% tax penalty if they are withdrawn earlier than five years after the first contribution. If you are older than 59 1/2 years of age, there is no penalty on withdrawing earnings from your Roth IRA.
There’s no solid answer for which retirement account is better. Ideally, you’ll want to have both a 401(k) set up with your employer and an individual retirement account such as a Roth IRA for personal contributions.
If your employer doesn’t offer a 401(k) plan, your options are more limited. Roth IRA is a good option in this scenario since it allows a great deal of investment freedom, and withdrawals are tax-free in retirement.
It’ll also enable the account holder to withdraw their own contributions at any time with no penalty.
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