Roth IRA vs. 401(k): What's the difference?

Roth IRAs can help you save for retirement and enjoy tax-free growth. However, 401(k)s can help you reduce your tax liability for the current tax year. So, which is better? 

It depends on factors like your income level and employment situation. Learn more about each by utilizing online tools and resources, which allow you to compare and contrast easily.

In order to determine which to choose, you'll need to understand the difference between each. Here's a closer look at both Roth IRAs and 401(k)s to help you decide if one — or both — can provide the best solution for your retirement savings. 

Roth IRA 

A Roth Individual Retirement Account (IRA) is a type of savings account that offers tax advantages in retirement. You make post-tax contributions and then can enjoy tax-free withdrawals once you're at least 59 ½. 

But it's not a free-for-all. The amount you can contribute each year is subject to limits set by the IRS. In 2022, the maximum remained at $6,000 per year, or $7,000 if you're age 50 and up. Additionally, you can only contribute directly to a Roth IRA in 2022 if your income is under: 

• $144,000 for single filers
• $214,000 if you're married, filing jointly
• $10,000 if you're married, filing separately

Once you hit the maximum income level, any excess direct contributions and resultant earnings are subject to a 6% tax for every year they are in the account. That said, high-income earners can avoid the penalty and still use a Roth IRA through a backdoor Roth IRA. If you need to make an early withdrawal, Roth IRAs allow for the penalty-free withdrawal of contributions once the account has been open for at least five years. Earnings withdrawals, on the other hand, will come with a 10% penalty until you reach 59 ½ years old.

If you're interested in opening up a Roth IRA account or switching over your current plan, you can get started here.

Pros

• Tax-free growth on contributions
• Penalty-free early withdrawals of contributions
• No mandatory withdrawals
• Backdoor Roth IRA workaround option
• Fees are typically lower than 401(k) plans

Cons

• Income limits restrict who can directly contribute
• No tax breaks on contributions 
• 10% penalty for early withdrawals of earnings
• Lower annual contribution limits ($6,000 to $7,000)
• No automatic payroll deductions

401(k)

A 401(k) is an employer-sponsored retirement account that offers tax advantages upfront. When you make contributions, you can deduct them on your tax return, lowering your taxable income for the year. Then, once you turn 59 ½, you can begin taking withdrawals from the account and they'll be taxed as ordinary income. 

While 401(k)s don't have income caps, they do limit how much you and your employer can contribute each year. In 2022, the maximum personal contribution limit was set at $20,500 per year if you're under 50, and $27,000 if you're 50 or older. Additionally, employer contributions are limited to 100% of your compensation or $61,000, whichever is less. Further, the limit is bumped up to $67,500 if you're 50 or older.  

As for early withdrawals, if you withdraw from your account before the age of 59 ½, the IRS will typically charge you a 10% penalty tax and withhold 20% for taxes. Alternatively, many 401(k) providers offer loans backed by your account funds which can be a helpful financial resource. 

Since 401(k)s are employer-sponsored, you can only get one if your employer offers it or if you're self-employed and set up a solo 401(k) for yourself.

Pros 

• Higher annual contribution limits ($20,500)
• Employer matching
• Contribute pre-tax dollars and lower taxable income
• No income limits
• 401(k) loans are often available
• Automatic payroll deductions

Cons

• Only available through participating employers
• Earnings are taxed
• Pay taxes on withdrawals in retirement
• 10% penalty on early withdrawals
• Fees are typically higher

Roth IRA vs. 401(k): Which is better?

Both Roth IRAs and 401(k)s can be beneficial, but which is better for you?

 In a perfect world, you could max out the contributions to both accounts and reap all the benefits. However, both may not be available or you may have limited funds to invest. When the latter is the case, here's what to consider.

• Contribution matching: Does your employer offer 401(k) contribution matching? If so, you'll typically want to take full advantage of the free money on the table. 
• Current and future income: If you expect to be in a higher tax bracket in retirement, a Roth IRA can be more advantageous. If your tax bracket is higher now, the 401(k) can be better. 
• Early withdrawals: You can withdraw contributions from a Roth IRA penalty-free after five years no matter your age. 401(k) plans don't allow penalty-free early withdrawals of any sort. They may offer loans backed by your savings though. 
• Contribution limits: With a 401(k), you can contribute more than three times what you can to a Roth IRA. 
• Income limits: 401(k)s have no income limits while high-income earners are restricted from direct Roth IRAs contributions. 
• Required distributions: A 401(k) requires you to begin taking distributions at age 72, a Roth IRA doesn't. If you want to pass a Roth IRA on to a beneficiary, you can do so without ever taking distributions from it. 
• Automatic payroll deduction: 401(k) plans offer the perk of automatic payroll deductions while Roth IRAs don't. 
• Fees: 401(k) plan fees tend to be higher than those for Roth IRAs. 

When both a 401(k) and Roth IRA are available, it's typically best to first ensure you max out your employer's 401(k) matching offer. Beyond that, weigh the above factors to figure out which account offers the best return on your investment for you. In some cases, such as when you've already maxed out your 401(k) contributions, the best solution may be a combination of both.

If you have a 401(k) that needs to be rolled over, you can find out the next steps you should take by clicking here.