401(k) vs Roth IRA

Understand the main differences between a Roth IRA and 401(k) retirement account in 2023

Most people who save for retirement have a few different options for retirement savings accounts– the main ones being a Roth IRA vs 401k. Each of these accounts have different tax and savings benefits that you can take advantage of, but which one should you choose?

Let’s check out each account to see which one is better for you at this stage in your life.


Differences Between 401k and Roth IRA

401k-vs-roth-ira

401(k)s and Roth IRAs are different types of retirement accounts with different contribution levels and tax benefits. A 401k is an investment accountant that must be sponsored by an employer while a Roth IRA account can be setup by an individual. Likewise, the 401k contributions and accumulated interest are tax deferred while the Roth IRA contributions are taxable with accumulated interested tax free. This means that you do not have to pay tax on the money you put into your 401k until you take it out. Conversely, the money  you put into your Roth IRA is subject to tax initially. Then it grows in the account and can be taken out years later tax free.

They both serve the purpose of helping individuals in preparing for their retirement, but they function differently. Let’s take a deeper look at both.


What is a 401(k)?

A 401(k) is the name of a type of retirement account that is described in the Internal Revenue Code of the IRS as an account where the employer sponsors part of the funds that go into it. A 401(k) is funded through contributions from both the employee and the employer. The contribution from employees is deducted from their paycheck directly and the contribution from employers is commonly described in the job contract.

These contributions are tax deductible (the ones made by the employee) and the earnings generated through the investment of these funds are not taxed until the account holder starts withdrawing his retirement funds.

Also, there are annual contribution limits set by the IRS for 401(k). Employees can contribute up to $19,000 per year if they are under 50 years old and up to $25,000 if they are over 50 years old.

Employers, on the other hand, usually contribute a percentage of the contribution made by the employee. While these contributions don’t count for the limit described above, there’s an annual limit for the total contributions a 401(k) can receive including both employee and employer contributions.

For those who are under 50 years old, the maximum annual contribution can be as high as $56,000 and for those who are over 50 years old, the cap is $62,000. On the other hand, these contributions can’t exceed the employee’s annual salary if the latter is lower than the limits described above.

The investment plans offered for 401(k) accounts vary from one firm to another but the fees associated with managing these accounts are usually low.


What is a Roth IRA?

A Roth IRA is a retirement account that is opened unilaterally by an individual without the involvement of his/her employer. This account is usually employed by self-employed individuals or by someone who wants to have a second retirement account to make further contributions that may exceed the contribution limits set by a 401(k).

The amount of the contributions made to a Roth IRA are determined by the account holder and they are not tax deductible, this means that the contributions are also not taxed when they withdrawn during retirement. On the other hand, after the funds go into the Roth IRA account, any capital gains received from the investment of the funds are not taxed until they are withdrawn.

Only certain individuals are eligible to open a Roth IRA account. Individuals who earn more than $137,000 a year are not allowed to contribute to a Roth IRA account, while individuals with an annual income that ranges from $122,000 to $137,000 or $193,000 to $203,000 for married couple, can only contribute a partial amount to the account.

The maximum annual contributions that can be made to a Roth IRA account are $6,000 for those who are under 50 years old and $7,000 for those who are over 50 years old.

One distinctive feature of Roth IRAs is that contributions are separated from gains, especially for tax purposes. Both can be withdrawn at any given point in time but only the withdrawals of earnings made on the investments are taxed. Additionally, some penalties may apply to early earnings withdrawals.

Roth IRAs are more flexible in terms of the investment alternatives offered to those who hold one of these accounts, which gives the holder much more freedom to make decisions on how to invest the funds deposited into the account.


Key Differences Between Roth IRA and 401k

The main differences between a 401(k) and a Roth IRA are:

Source of the contributions: A 401(k) allows that both the employee and the employer make contributions to the account based on the arrangement described in the job contract, while a Roth IRA only receives contributions from the holder of the account, as his/her employer is not involved at all.

Taxation: Contributions to 401(k) accounts are tax deductible and any earnings made on the investments are not taxed. Both contributions and earnings are taxed only if they are withdrawn. On the other hand, contributions made to Roth IRAs are considered as after-tax deposits, which means that any withdrawal of these contributions is not taxed. The earnings received from the investment of those contributions are not taxed while they remain in the account but they are taxed if they are withdrawn before the retirement period.

Contribution limits: The annual contribution limits of 401(k) are considerably higher than the limits established for Roth IRAs.

Investment plans: The investment plans offered for 401(k) accounts vary significantly from one firm to another but they are usually limited to a selection of assets, while a Roth IRA gives the investors a large degree of freedom to decide where to allocate the funds.


Roth IRA and 401k Retirement Example

Jeremy is currently 42 years old and he’s a Junior Partner at a law firm. He earns a salary of $99,500 per year and the firm has set for him a 401(k) that matches 50% of the contributions he makes, up to 10% of his salary. He’s quite happy with this arrangement but since he has no major expenses, he has decided to set a separate retirement account, a Roth IRA to supplement his retirement income.

Given that Jeremy earns less than $122,000 per year, he can make a full contribution to his Roth IRA, which means that he can add up to $6,000 per year to it. He also wants to invest those funds freely, as the funds deposited on his 401(k) are invested by law firm’s pension fund.


Roth IRA vs 401k Comparison Table

ComparisonRoth IRA401(k)
MeaningA retirement account that allows people to contribute post tax income and withdrawal earnings tax free in future years.A retirement plan established through employers that allows employees to contribute pre-tax wages and receive tax deferred withdrawals in the future.
ContributionContributions are post-tax income.Contributions are pre-tax wages.
DistributionDistributions are not taxable since the initial contributions were already taxed.Distributions are taxable since the contributions were made with pre-tax wages.
UsageA Roth IRA is most useful for individuals with many years until retirement, as there investments can grow and be distributed tax free.A 401K is most useful for individuals who want to minimize their current taxable income and receive a tax deferral in future years.

Bottom Line

401(k)s and Roth IRAs are both individual retirement accounts that are designed to fulfill different needs. 401(k)s are usually the primary retirement account of employed individuals while Roth IRAs are used to supplement 401(k)s. On the other hand, for self-employed individuals, Roth IRAs are useful as they don’t require that there’s an employer involved.