Roth IRA vs. 401(k): Differences, Pros & Cons (2024)

Difference Between a Roth IRA and a 401(k)

The primary difference between a Roth IRA and 401(k) is that IRAs are individual retirement accounts established by an investor and 401(k)s are retirement benefits sponsored by an employer on behalf of its employees. Other differences may include tax treatment, rules for withdrawal, and maximum contributions.

Comparing a Roth IRA vs 401(k), the main differences are:

Note: Many 401(k) plans offer Roth after-tax contributions, in addition to the traditional pre-tax contributions. For example, if a 401(k) plan allows for Roth designated contributions, and an employee chooses to make this type of elective deferral, these contributions receive the same tax treatment as a Roth IRA, such as after-tax contributions and tax-free withdrawals after certain IRS-set qualifications are met. However, the Roth 401(k) contributions allow for higher limits (up to $27,000 including catch-up contributions, in 2022) compared to the Roth IRA.

401(k)s

A 401(k) is an employer-sponsored, defined-contribution, retirement savings plan. 401(k) plans have unique features and benefits, such as high contribution limits, automatic payroll deductions, and potential for employer matching contributions.

• Contributing to a 401(k): Once an individual meets a 401(k) plan's initial eligibility requirements, they may choose a contribution amount, usually as a percentage of gross pay. Contributions can be made through automatic payroll deduction.
• Investment Options: After choosing their contribution amount, a participant may choose investments, which is typically a set of 8-12 mutual funds. Most 401(k) plans don't offer investment options beyond the select list of mutual funds.
• Taxes: Traditional 401(k) contributions go in on a pre-tax basis. Withdrawals at retirement are taxed as income at the individual's federal income tax rate. State income taxes also apply, where applicable. Roth 401(k) contributions, if available, go in on an after-tax basis. All contribution types grow tax-free.
• Limitations: There are no income limits for making 401(k) contributions. However, contributions are limited to a maximum of $20,500 per year, plus an additional $6,500 for individuals age 50 and up.
• Early Withdrawals: 401(k) early withdrawals may be allowed for hardship reasons but the individual must generally pay a 10% early withdrawal penalty for withdrawals made before age 59 1/2.
• Employer Matching: Employers may make matching contributions, which typically adheres to a certain formula, such as 50% of employee deferrals, not exceeding 3% of employee income. For example, to receive the full employer match in this case, the employee would need to contribute 6% of their pay.
• Fees: 401(k) plans typically charge fees, which may range from 0.5% to 2.0%, depending upon the size of the employer and the size of the plan's assets and number of employees. These fees may be charged to the plan trust and thus, not clearly evident to the 401(k) participant.

Advantages

• Convenience: 401(k) contributions are automatically made through payroll on a periodic basis.
• Transferability: After terminating employment, a 401(k) participant may choose to transfer their account's balance into an IRA or they may transfer it to a new employer's 401(k) plan, if applicable, without any tax consequences.
• Tax advantages: accounts grow tax-free and traditional, pre-tax contributions reduce taxable income.
• Dollar-cost averaging: contributions are invested periodically, which helps to average the cost, and the market risk of investments, lower over time.
• Compound interest: Interest, dividends, and capital gains from investments in a 401(k) stay in the account and "compound" to grow the account faster over time compared to regular deposit accounts.
• High contribution limits: The maximum annual contribution is $20,500 for 2022. By comparison, the maximum contribution for an IRA in 2022 is $6,500 per year.
• Shelter from creditors: The Employee Retirement Income Security Act of 1974, or ERISA, protects 401(k) accounts from claims from creditors.
• Possibility of employer contributions: Employers may make matching contributions, which work like a bonus on top of the account owner's contributions.
• Hardship withdrawals and loans: Under certain qualifying conditions, a 401(k) participant may make a hardship withdrawal from their account balance. Some 401(k) plans offer loans.

Disadvantages

• Limited investment selection: 401(k) participants typically can only choose from a pre-selected set of investment choices, which are usually mutual funds.
• Lack of control: Although the vested account balance belongs to the participant, plans generally don't allow withdrawals, unless certain qualifying conditions are met.
• Potential for high fees: Some plans have administrative fees and investment costs that are higher than other investment accounts, such as IRAs.
• Early withdrawal penalty: Withdrawals from a 401(k) before age 59 1/2, will generally incur a 10% early withdrawal penalty from the IRS.

Roth IRAs

A Roth IRA is an individual retirement account that is funded with after-tax dollars. Investments in a Roth IRA grow tax-free while held in the account and Roth IRA withdrawals are generally tax-free if taken at or after age 59 1/2. This differs from a traditional IRA, which is funded with pre-tax dollars and withdrawals are taxed as income.

• Contributing to a Roth: Roth IRA contributions are set up by the individual account owner at their chosen brokerage firm and are made on an after-tax basis.
• Taxes: Money held grows tax-free and withdrawals are generally tax-free if made at or after age 59 1/2.
• Limitations: Income limitations for a Roth IRA in 2022 are $214,000 for married filing jointly and $144,000 for single filers.
• Early Withdrawals: Withdrawals made prior to age 59 1/2 will generally incur a 10% early withdrawal penalty from the IRS.
• Employer Matching: Since a Roth IRA is a retirement account established and maintained by an individual, there are no employer matching contributions to a Roth.
• Fees: Many discount brokerages allow for free account setup. However, expense ratios from mutual funds and ETFs still generally apply. If an investor chooses to open a Roth IRA with a full service broker, the investor may pay commissions and similar fees to the broker or advisor.
• Investment Options: Depending upon the brokerage where the account is held, a Roth IRA potentially has unlimited investment options, including stocks, bonds, mutual funds, ETFs, and options.

Advantages

• Tax-free growth of contributions: There are no taxes on interest or capital gains while money is held in a Roth IRA.

• Tax-free withdrawals of principal at any time: Since contributions are made on an after-tax basis, these contributions may be withdrawn free of tax. However, interest and capital gains are taxed if withdrawn from a Roth IRA.
• Tax-free withdrawals at retirement: Withdrawals taken at or after age 59 1/2 are generally tax-free.
• No required minimum distributions (RMDs): Unlike traditional IRAs, Roth IRA account holders are not required to make minimum distributions at any age.

Disadvantages

• No tax deduction: Roth contributions are made on an after-tax basis, which means they won't reduce taxable income.
• Income limits: Married individuals filing a joint tax return with income over $214,000 and single filers with income over $144,000 cannot make Roth contributions, under 2022 rules.
• Contribution limits: Roth contributions in 2022 are limited to $6,000 per year for age 50 and under and $7,000 for age 50 and over.
• 5-year rule on withdrawals: To avoid the 10% early withdrawal penalty, in addition to the 59 1/2 age requirement, a Roth IRA must be open for at least five years.

Traditional IRA vs. Roth IRA vs. Roth 401(k) vs. 401(k)

The key difference between a traditional IRA vs Roth IRA is that traditional contributions are made on a pre-tax basis and Roth contributions are made on an after-tax basis. Withdrawals from a traditional IRA are taxed as income, whereas qualifying Roth IRA withdrawals made at retirement are tax-free.

The same differences between traditional and Roth IRAs apply to the traditional 401(k) vs Roth 401(k). Traditional 401(k) contributions are pre-tax and withdrawals at retirement are taxed as income. Roth 401(k) contributions are after-tax and qualifying withdrawals at retirement are tax-free.

Tips When Choosing How To Invest for Retirement

General guidelines for retirement saving are that individuals should contribute at least enough to a 401(k) plan to receive the full employer match, if applicable. In some cases, it can make sense to use an IRA in addition to a 401(k). Investment selection and traditional vs Roth contributions will depend on a range of factors, including age and income.

Considerations for choosing how to save and invest for retirement are:

• Take advantage of a match: If an employer offers a match, it's almost like free money. If a budget allows, it's generally wise to contribute at least enough to receive the full employer match.
• Consider an IRA: If a 401(k) is not available, investors may consider taking advantage of an IRA for retirement savings. Some investors use an IRA, either to add a Roth option when one isn't available in a 401(k), to expand the investment options, or to maximize annual contributions, if applicable.
• Maximize contributions when possible: For those retirement savers who are fortunate enough, and when the budget allows, contributing up to the annual allowed amount will maximize retirement savings.
• Invest for risk tolerance and time horizon: When it comes to the investments, the primary determining factors are tolerance for risk (the ups and downs) and time horizon (the number of years until withdrawals begin).

Bottom Line

The key difference between a Roth IRA and a 401(k) is that a Roth IRA is an account established by an individual and a 401(k) is a benefit established by an employer for the benefit of its employees. From there, the main differences remaining revolve around income limits, contribution limits, and withdrawal rules.

Kent Thune