Roth IRA vs 401K: What is the Difference?

If you’re just beginning to think about saving for retirement, you may be confused about what kind of retirement account to open. You’ve probably heard of 401(k)s and Roth IRAs but may not understand the difference between a ROTH IRA vs 401Ks. Which should you choose? Do you even have a choice, or is it up to your employer? What are the advantages and disadvantages of each kind? Is there a way to have both a ROTH IRA and a 401K?

Here are the basics about these two popular types of retirement accounts, and how to choose between them.

The 401(k)

First, let’s start with that strange name. Why is it called a 401(k)? This type of plan is named after the subsection of the IRS code in which it is described. There are other, less popular plans, with similar names, such as the 401(a) and 403(b).

The 401(k) is by far the most common employer-based plan. Because it’s employer-based, it’s only an option for you if you work for a company that offers it as a benefit. Under the plan, each time you get paid, your employer directs a portion of your wages to your retirement account. This can be a big advantage, because it happens automatically, without any effort on your part other than enrolling and selecting the portion of your paycheck you’d like to go towards your retirement. Even better, many employers will match the amount you choose to invest, often to the tune of 50%, up to 6% of your salary. That would mean that if you elected to send $100 into your retirement each paycheck, your employer would add another $50 for a total contribution of $150. Given the power of compounding interest, that can be an enormous boost to the growth of your account.

Obviously, the funds you put into your account don’t just sit there collecting interest. They’re invested in stocks and bonds so that they grow and grow throughout your working life. However, with a 401(k), employees have little control over how their assets are invested. Instead, the employer chooses a manager that makes decisions about the portfolio.

One of the most important things to understand about the 401(k) is that it is funded with pre-tax income. In other words, your employer sends money to your retirement account before you’ve paid any income taxes on it. At some point, just like the devil, the IRS always gets its due. When it comes to the 401(k), those dues are paid later on, after you’ve retired and you begin withdrawing funds from your 401(k). You’ll then be required to pay income tax on your withdrawals.

Speaking of making withdrawals, if your account is a 401(k), you will be obligated to begin taking “Required Minimum Distributions” (RMD) upon reaching the age of 73. The amount of your RMD varies according to the size of your account and your life expectancy according to the IRS.

Another feature of the 401(k) is that you will be penalized for making any withdrawals from your account before you reach the age of 59.5. If you do end up making such an early withdrawal, you must pay income tax on the funds you take out, plus a 10% penalty on top of that.

The Roth IRA

If the 401(k) gets its name from the IRS code, what about the Roth IRA? The “Roth” part of the name comes from US Senator William Roth, who is considered the principal architect of these retirement plans, which were codified through the Taxpayer Relief Act of 1997. In common parlance, “IRA” stands for Individual Retirement Account, although technically the IRS calls it an Individual Retirement Arrangement. In either case, what’s important is the “independent” part, which underscores one of the Roth’s key differentiators from 401(k)s…Roth IRAs are not employer-managed but rather set up by individuals on their own, working with brokerages. You can set up a Roth IRA with investment companies such as Schwab, Fidelity, and Vanguard.

Because it’s an individual account, you control not just how aggressively you fund it, but also how it is invested. With a 401(k), your funds are invested according to the risk tolerance of the manager, but with a Roth IRA, it’s up to you. You might want to invest very heavily in stocks for much of your working life, choosing to only switch to less risky bonds as you get very close to retirement. That might be a questionable strategy, but if you choose to do it, no one will stop you.

Roth IRAs are funded with after-tax dollars. That sets them apart not only from 401(k)s but also from Traditional IRAs. Because you’re contributing money that has already been taxed by the government, you won’t have to pay taxes when you begin to withdraw funds during retirement.

You can begin withdrawing from your Roth IRA penalty-free before you’ve attained the age of 59.5, as long as the account has been open for at least five years.

Roth IRA vs 401k: Which should I choose?

First of all, do you have a choice? If you’re not working for an employer that offers a 401(k), the question becomes moot. You should be saving for retirement, and since a 401(k) isn’t an option, you’ll need to open an IRA.

But if you do face the choice between these two types of plans, let’s review their key differences:                                                                                              

As you can see, there’s no right or wrong answer here. Each type of plan has its differences, and sometimes these might appear as advantages to some people and disadvantages to others. For example, being responsible for your investment choices under a Roth IRA might be desirable to some but overwhelming to others. And some people are happy to pay taxes on their withdrawals during retirement in exchange for being able to reduce their tax bill while they’re working, as under a 401(k), while others would rather bite the bullet now so they don’t have to worry as much about taxes when they’re done working.

Some people choose to divide their assets between a 401(k) and a Roth IRA. Doing so has a few advantages. First, because both types of plan have annual contribution limits, aggressive savers can put more money away by having both kinds of account. Second, because you can withdraw from a Roth IRA without penalty, you can use that account as a kind of emergency fund while leaving your 401(k) untouched. And finally, having both a 401(k) and a Roth IRA means you can deduct some of your tax contributions each year. And after you reach age 73, when you’re forced to take Required Minimum Distributions from your 401(k), you can let your Roth IRA assets continue to grow, perhaps even leaving them as a legacy for your family.

But if you’re truly torn between these two types of retirement plan and you have an employer willing to match your contributions to a 401(k), do not underestimate the power of this advantage. The very most important thing you can do to secure your retirement is to contribute the most possible during your working years. Having someone else put their money into that account for you is no small thing.