If you’re well aware that you need to save for retirement, that’s great! However, with all of the alphabet soup combinations available (SEP, SIMPLE, 401(k), Roth IRA) that it’s possible to choose from, which one is best? More specifically, if you’re torn between Roth IRA vs. 401(k), let Benzinga simplify it for you.
Best Retirement Advisors
Before we dive into the differences between a Roth IRA and a 401(k), let's go over Benzinga's top picks for best retirement advisors.
What is a Roth IRA?
A Roth IRA is an individual retirement account that offers tax-free growth and tax-free withdrawals in retirement. Roth IRA rules stipulate that as long as you’ve owned the account for five years and you’re age 59 ½ or older, you can withdraw money when you want without paying federal taxes.
A Roth IRA is a wonderful investment vehicle when you believe your taxes will be higher in retirement than they are right now. That’s why it’s a great option for young people who have just started their first job because it’s likely that their taxes will be higher in retirement.
In addition, you can withdraw your contributions at any time without taxes or paying a penalty. You can use up to $10,000 to purchase a first home for yourself or certain family members. In addition, you can pay for higher education costs for yourself or a family member. You’ll still pay income taxes if you withdraw earnings early, however.
What is a Traditional 401(k)?
Named after the tax code that governs them, 401(k)s came out in the 1980s as a way to supplement pensions. A 401(k) is an employer-sponsored retirement savings plan. Employees save and invest part of their paychecks before taxes are taken out. Taxes aren’t paid until the money is withdrawn from the account.
Traditional vs. Roth IRA: Tax Considerations
Roth IRAs differ from Traditional IRAs in several ways.
- Roth IRAs provide no tax break for contributions, but earnings and withdrawals are generally tax-free. You avoid taxes when you put money into a Traditional IRA but with Roth IRAs, you avoid taxes when you take money out in retirement.
- You encounter income limits for Roth IRAs.
- Traditional IRAs require you to take mandatory taxable withdrawals of a certain percentage of your funds at age 70 ½ and Roth IRAs do not. You may be eligible for a tax credit (called the Saver’s Credit) for making contributions to your 401(k), depending on your adjusted gross income. You’ll also need to be age 18 or older, not a full-time student and not claimed as a dependent on anyone else’s tax return.
Tax Considerations for a Traditional 401(k)
When you invest in a Traditional 401(k), you’re investing pre-tax dollars, which means that your money is taken out of your paycheck before taxes. You’ll therefore lower your taxable income.
- If you withdraw funds before age 59 ½, you’ll pay taxes on the amount you withdraw, in addition to paying a penalty.
- You may be eligible for a tax credit (called the Saver’s Credit) for making contributions to your 401(k), depending on your adjusted gross income. You’ll also need to be age 18 or older, not a full-time student and not claimed as a dependent on anyone else’s tax return.
Who Qualifies for a Roth IRA?
Anyone who earns income and meets certain income requirements can qualify for the best Roth IRA.
- Single tax filers must have modified adjusted gross incomes of less than $138,000 in 2023 to contribute to a Roth IRA. Contribution limits are phased out until you reach a modified adjusted gross income of $153,000 in 2023.
- Married couples filing jointly must have a modified adjusted gross income of less than $218,000 in 2023 to contribute to a Roth; contribution limits are phased out starting at $228,000 for 2023.
Who Qualifies for a Traditional 401(k)?
Any employee who meets the following requirements can qualify for his or her employer’s sponsored plan:
- Has reached age 21
- Has worked at the company for at least a year, though a traditional 401(k) plan may require 2 years of service to become fully vested. However, the employer must allow the employee to participate in elective deferral contributions after one year of employment.
Max Contributions for Roth IRA and 401(k)
For 2023, contribution limits for Roth IRAs are $6,500 and $7,500 for those who are 50 or older, and the elective deferral limit is $22,500 for a 401(k).
Investing in Both Roth IRAs and Traditional 401(k)s
If your employer contributes to your 401(k) because you do (never pass up your employer’s match) and you like the characteristics of a Roth IRA, then it’s a great idea to contribute to both.
If you like the idea of a Roth IRA but prefer to keep the same advantages of a Roth housed within your employer’s plan, the right idea for you may be a Roth 401(k). A Roth 401(k) is an employer-sponsored investment account funded with after-tax money. This type of investment account, again, like a Roth IRA, is well-suited to people who believe that they will be in a higher tax bracket in retirement.
Tax Rate During Retirement
You’ll still be taxed in retirement, even if you aren’t making money from a job, on the following (these are the most common):
- Social Security income
- IRA and 401(k) withdrawals
- Pensions
- Annuity distributions
- Investment income
- Gains if you sell your home
If you stick to a Roth IRA, you're home-free, tax-wise. Therein lies the benefit of the Roth IRA.
Choose the Best Option for You
Which is best: Traditional 401(k) vs. Roth IRA? This can be a tough call if you qualify for both and are trying to decide between one or the other. Nobody knows what the tax laws will be when you retire. Ultimately, the differences come down to two different types of tax advantages, investment options overall and employer contribution possibilities.
However, one thing is for sure — it’s smart to take advantage of your employer’s contribution toward your 401(k), so contribute what you need to to get the full match. It’s a possibility to then take advantage of all the Roth IRA has to offer, and if your employer doesn’t offer a match, then investing only in a Roth IRA could be your best bet.
Ready to start investing for the future? Check out Benzinga's breakdown of a brokerage account vs. an IRA account.
Frequently Asked Questions
Is it better to put money in a Traditional 401(k) or Roth IRA?
Roth IRA accounts often have better investment options and additional tax benefits. But you should still max out your employer benefit for your Traditional 401(k).
Is it better to put money in a Traditional 401(k) or Roth IRA?
If you think you’ll be in a higher tax bracket during retirement or believe you will earn high returns in your account, it may be better to invest in a Roth IRA. But if not, a Traditional 401(k) may be the better option.
Should I have both a Traditional 401(k) and Roth IRA?
Yes, having both helps you maximize the tax advantages each has to offer.
Should I split contributions between a Traditional 401(k) and Roth IRA?
You might not split your contributions evenly but instead strategically max out the benefits of each to set yourself up for success in retirement.
About Rebekah Brately
Rebekah Brately is an investment writer passionate about helping people learn more about how to grow their wealth. She has more than 12 years of writing experience, focused on technology, travel, family and finance. Her work has been published in Benzinga, Hearst Bay Area, FreightWaves and Dallas Observer publications.