Updated: Mar 27
We tell you everything you need to know about Roth IRA vs 401K vs Roth 401K and which one makes the most sense for you.
Who is eligible for a Roth IRA vs Roth 401K vs Traditional 401K? It depends! Anyone is eligible for a Roth IRA and can create one at any point. The main caveat here is that you cannot contribute to the account unless you have earned income. That means you have to earn income in that year that is reported in a tax return.
For a Roth 401K and Traditional 401K, these are retirement accounts offered by an employer, which means the employer you work for has to offer this option. You're not able to open one up on your own. If you are employed full-time, you will be eligible for a 401K plan and contribution, but you may not be eligible to contribute until after a certain period of time. This will vary from employer to employer. If you don't know what your job offers, you just know it's a "401k", it's most likely a Traditional 401K as that is the more common one.
Employers may offer only one option (either a Traditional 401K or a Roth 401K), but offering both options are becoming more popular. You can to contribute to one or both retirement accounts if your employer does offer both options.
This is a major difference between Roth IRA vs Roth 401K vs Traditional 401K. In Roth IRAs and Roth 401Ks, you put in after-tax dollars into account, BUT your earnings are completely tax-free. That means, if you started with $10,000 in your Roth IRA account and you see a 10% year over year return for the next 20 years, your new balance in 2042 is $67.2K. You will not be taxed on this balance if you meet the withdrawal requirements (see Withdrawal Options).
A Traditional 401K allows you to put in pre-tax dollars, BUT your earnings are taxed. In the same scenario above, you will be taxed on any distributions you take out on the $67.2K balance. You have to be careful because the amount of money you take out of a traditional 401K isn't what you really have available to you if you consider the tax amount that needs to be paid. It's less attractive to be aggressive on your Traditional 401K account because the higher your account value, the more taxes you will pay. That's why most people keep a Roth IRA as it's a way to grow money completely tax-free.
For Roth 401Ks and Traditional 401Ks, the contribution limit is pretty substantial. For example, in 2021, the contribution limit was $19,500/year for anyone younger than 50. In 2022, the contribution limit was increased to $20,500/year for anyone younger than 50. For those older than 50, the contribution limit is increased to $27,000/year to allow for a "catch up". But if you don't remember from my Money Mindset post,
For Roth IRAs, the contribution limits are much lower compared to a Roth 401K and a Traditional 401K and there is a income limit to contributing. Why? Because your earnings are tax-free! It's a great deal, hence why the limits are so much lower compared to a 401K. In 2022, the contribution limit is $6,000/year for anyone under 50. Those 50 and older can contribute $7,000/year.
What are the income limits for a Roth IRA? Contributions start being reduced or "phased out" starting at $129,000 for an individual. Anyone who earns more than $144,000 will not be able to contribute to a Roth IRA at all. If you're married and filing jointly, contributions start being reduced at $204,000 and any household income greater than $214,000 will not be able to contribute to a Roth IRA at all. There is a legal way around this called a backdoor Roth IRA.
The contribution limits for all of the retirement accounts do change often so always make sure to Google the rules each year or ask your accountant so you're aware of how much you can contribute.
Since Roth IRAs are not a company sponsored plan, there are no employer matches for any contributions you make to a Roth IRA.
Roth 401Ks and Traditional 401Ks are eligible for an employer match. The match details will depend on your specific employer. But what exactly does a company match mean? It's when the company contributes to your 401K when you contribute to your 401K. That means, you're getting free money in your 401K. There is of course a catch. You will most likely need to be vested in the company prior to keeping the company match. For example, say I work at Company A. Company A offers a 100% match for contributions up to 2% of your salary and then a 50% match on any additional contributions up to 6% of your salary. In laymen's terms, if you contribute 2% of your salary to your 401K, Company A will also contribute 2% of your salary to your 401K. If you contribute 6% of your salary to your 401K, Company A will contribute 4% of your salary to your 401K. You get full match at 2% and then for every percentage up to 6% (6%-2%=4%), Company A will contribute 50% of what you put in (50% of 4% = 2%). Therefore, their total contribution is 4% to your 401K.
Withdrawal options are pretty limited for Traditional 401Ks - it's actually recommended that you take a loan out against your 401K rather than withdrawing from your 401K before age 59.5. If you decide to withdraw from a 401K before 59.5, you not only pay a penalty, you also pay taxes on the withdrawal. If you decide to withdraw $10,000 from your Traditional 401K, you may only have $7,000 in your pocket because the other $3,000 will go towards taxes and penalties. There are exceptions, but they are very limited. Consult a professional to understand what those exceptions are. Once you are 59.5 or older, there are no penalties in withdrawing from your 401K, but you will still pay taxes.
For Roth IRAs and Roth 401Ks, there is a possibility you can withdraw from your account early without having to pay penalties. If you are under the age of 59.5 and have had your account open for at least 5 years, you can withdraw from your Roth IRA or Roth 401K if you have a permanent disability, a beneficiary withdraws from your account after your death. The two additional benefits of Roth IRAs are that you can withdraw money to use towards a down payment of a house and you can withdraw up to your contribution amount at any point without a penalty. Roth IRAs provide a lot more flexibility and allow you to access the money you need earlier than other retirement accounts do.
The other call out is that Roth 401Ks and Traditional 401Ks require anyone 72 and over to take required minimum distributions (RMDs). If you do not take withdrawals, you will receive a penalty.
This one is fairly simple. Because Roth 401Ks and Traditional 401Ks are employer sponsored plans, there are not many investment options to choose from. It's whatever mutual funds are offered by your employer. I typically see a lot of target funds and a few options for small-cap, mid-cap and large-cap mutual funds. The downside of mutual funds are that they have fees - make sure you review the fees before investing in them to understand how much it might be costing you.
Roth IRAs are superior in that you can invest in almost anything - bonds, stocks, options, mutual funds, exchange-traded funds and even real estate. If you're familiar with covered calls, you can also sell calls in your Roth IRA as well. There are many options available!
Which one is right for me?
At this point, your head is probably spinning. Which is better for you? Both. If you can contribute to both, it's actually best to have a Traditional 401K or Roth 401K and a Roth IRA. Having both will allow you to keep your safer investments in your 401K, while making bigger investments in your Roth IRA (ETFs, stocks, etc) that might generate a better return.
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