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Key takeaways:
- Neither is better. Both 401(k)s and Roth IRAs offer you tax-advantaged ways to save for retirement; you’ll save on taxes now with a traditional 401(k) and later with a Roth IRA
- Both types of savings have unique requirements and restrictions in terms of eligibility, investment options, and more
- If possible, experts recommend that you first take full advantage of any 401(k) matching funds, then max your Roth IRA contributions, and then go back to contribute as much as you can to your 401(k)
When saving for retirement, is it better to contribute to a Roth IRA or a 401(k)?
To be honest, it’s a bit of a trick question because neither is technically better—they’re simply different. And if you can, you should consider contributing to both.
6 Differences between Roth IRAs and 401(k)s
Both a Roth IRA and a 401(k) allow you to save on taxes—you’ll save now with the traditional 401(k) and later with the Roth IRA. But there are some key differences between the two retirement savings programs.
1. Eligibility
Not everyone can contribute to a Roth IRA. The IRS limits your participation in a Roth IRA based on your tax filing status and your earnings, known as your modified adjusted gross income (MAGI). If you are married filing jointly and have an AGI of more than $228,000, or you’re single/married filing separately and your AGI is more than $153,000, a Roth IRA is not an option for you.
To be eligible for a 401(k), you must work for an employer who offers one. Additional requirements vary. For example, some employers require you to work for at least one year before you can participate, while others allow brand new employees to jump in as long as they are 21 years old. Some companies only offer a 401(k) to full-time employees, but part-time employees who work at least 500 hours over three consecutive 12-month periods may also participate in their employer’s 401(k).
Call-out: Employer matching contributions
Many employers match your 401(k) contributions, up to a certain percentage. For example, your employer may add $1.00 for every $1.00 you contribute, up to 3% of your earnings. You’re encouraged to take full advantage of this match because it’s basically free money. More good news: the matching funds do not count towards your IRS contribution limits.
2. Contribution limits
If you are fully eligible, the maximum amount you can contribute in 2023 to your Roth IRAs is $6,500 ($7,500 if you're age 50 or older). If you’re married filing jointly or a qualifying widow(er) and you make more than $218,000 but less than $228,000, or if you’re single, head of household, or married filing separately and you make more than $138,000 but less than $153,000, you can still contribute, but at a reduced amount .
Your 401(k) contribution limit is significantly higher—$22,500 for 2023, or $30,000 if you’re age 50 or older. And don’t forget—when you contribute to your 401(k) with pre-tax dollars, this means that you’re reducing your taxable income by that same amount, which lowers the amount of income tax you must pay.
3. Investment options
With a Roth IRA, you’ll have almost unlimited investment choices, allowing you to choose from mutual funds, index funds, bond funds, and more. Some people like to mix and match the investments in their Roth IRA investment portfolio themselves, while others prefer the simplicity of something like a Target Date mutual fund which builds a portfolio within the fund itself to balance risk based on your planned retirement schedule.
Investment options are usually more restricted within a 401(k); you’re limited to whatever funds your employer offers. Be sure to consider a fund’s expense ratio when choosing your 401(k) investments.
4. Vesting schedule
Your contributions and earnings in a Roth IRA are always yours, but you must leave your money invested for at least five years before you can make any qualified withdrawal. This IRS rule applies to everyone, regardless of your age or retirement status.
The money you contribute to a 401(k) also belongs to you, but employers have various rules regarding your ownership of their matching contributions. These rules are usually based on how long you’ve worked with the company. Some employers gradually give you ownership of the employer contributions over time, called graded vesting, while others give you full vesting a certain number of years after your date of hire, which is called cliff vesting. If you leave the company before you are fully vested under either scenario, you will probably lose the unvested money.
5. Withdrawal rules
Roth IRAs have no required minimum distributions (RMDs). This means that if you’re 59-1/2 years or older and have had the money invested in your Roth IRA for at least five years, you can take as much or as little out as you want penalty-free. This gives you a lot of flexibility during retirement in terms of when to take distributions.
With a 401(k), there are also penalties for making withdrawals before age 59-1/2, but you must begin taking RMDs at age 73. RMDs are determined by the IRS, using a formula based on your age, life expectancy, and account balance. Since you’ll be taxed once you start taking these required distributions from a traditional 401(k), it’s important to plan for this expense if you have one.
6. Tax obligations
When you contribute money to your Roth IRA, you will have already paid income tax on it. That money then grows tax-free, which means you won’t pay tax on either the money you invested or on the earnings that build up over time. Every penny that comes out of your Roth IRA will be tax free, making a Roth IRA a great way to diversify your retirement savings.
The amount you contribute to a 401(k) reduces your taxable income when you make the contribution, which lowers the amount of income tax you must pay at the time. But when you take withdrawals from a traditional 401(k) in retirement, that money will be taxed. While most people are in a lower tax bracket during retirement, this is still an expense for which you must plan.
Final Thoughts
If you can, you should consider contributing to both, but if you have limited funds—like most of us do— you should prioritize your contributions. Experts recommend that you first take full advantage of any matching funds your employer offers in your 401(k) by contributing at least to that level, which essentially doubles your investment. Then, if you’re able, make the maximum contribution to your Roth IRA. And if you still have money available to set aside for retirement, go back to your 401(k) and put the maximum allowable towards that.
When it comes to retirement plans, there’s something for everyone. 401(k)s give you a solid way to save, but even if you are contributing the maximum amount allowed by the IRS to your 401(k), you should still consider contributing to a Roth IRA. And, by contributing to both, you’ll give yourself flexibility when it comes time to start taking distributions. Doing both gives you peace of mind and freedom to enjoy your retirement!
This article is for informational purposes only. It does not replace financial or tax advice. Be sure to consult a tax or financial professional before making any decisions regarding your Roth IRA or 401(k).
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
