Roth IRA vs. 401(k): Which Should You Choose?

The Roth IRA and 401(k) are two of the most popular retirement accounts. Choosing which strategy is best for your circumstance can be a tough decision. This article will compare the benefits of choosing a Roth IRA vs. 401(k) and help you decide where to save and invest for the long run.

What are the differences between investing in a Roth IRA vs. 401(k)?

The first significant difference between investing in a Roth IRA versus a 401(k) plan is how you go about making contributions. With a Roth IRA, the onus is on you to open the account (usually at a popular online brokerage company’s website) and then fund it.

The second significant difference between a Roth IRA and 401(k) is the tax treatment. Roth contributions are made after-tax, while regular 401(k) deferrals are done pre-tax.

That means you pay income tax today when putting money into a Roth IRA, while you get a current-year tax deduction when making 401(k) contributions.

It’s a great deal. Employer contributions are made pre-tax, regardless of whether you elect regular pre-tax contributions or Roth. Of course, there is no employer match with a Roth IRA.

The IRS also allows you to take out earnings from a Roth IRA penalty-free in some situations. Some of the more common reasons to take the earnings out of a Roth IRA early include money for a first-time home purchase, qualified education expenses, qualified medical expenses, and for disability or death. You can view the IRS list of all the reasons here.

Beyond traditional 401(k)s, how do Roth IRAs differ from Roth 401(k)s? Another trend that has emerged in the 401(k) space is the offering of a “Roth” 401(k). A Roth 401(k) works like a Roth IRA in some ways and like a 401(k) in other ways. We know that “Roth” means contributions are made after-tax.

Roth IRAs Offer Withdrawal Flexibility vs. A Roth 401(k) A Roth IRA differs from a Roth 401(k) in that contributions made to a Roth IRA can be withdrawn tax-free and penalty-free at any time. Inside a Roth 401(k), the plan participant faces a 10% early withdrawal penalty on withdrawals made before age 59½.

Beware of Roth IRA Income Limits You will not be able to contribute to a Roth IRA if your income exceeds certain thresholds. A Roth 401(k) does not have an income limit. For Roth IRAs, retirement savers should review rules determined by the IRS.

Required Minimum Distribution Rules Required Minimum Distributions (RMDs) are something to be mindful of with 401(k) plans. Your RMD is the minimum amount you must withdraw from your retirement account each year. The IRS does not allow retirees to leave money in a tax-sheltered vehicle.

When should you choose one vs. the other (or a mix of both)? If a company requires a worker to remain with the firm for five years before the match is vested, putting your first savings dollar into the plan might not make sense. Nevertheless, contributing to a 401(k) up to the match is often a good first step toward saving for retirement.

Consider your current tax rate versus your tax rate in retirement when deciding on pre-tax or Roth contributions. If you are in a relatively high tax bracket today, pre-tax contributions might be the better play. Also, weigh the flexibility of a Roth IRA versus sometimes-stringent 401(k) plan rules. If you might need to pull money out of your retirement accounts, a Roth IRA is a better option.

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