Roth IRA vs 401(k)

When it comes to opening accounts to save for retirement, two of the most common options are the Roth IRA and the 401(k) accounts. Each account has its own perks, drawbacks and requirements, so which one is better?

Starting with a Roth IRA, the investor contributes to this retirement account with after-tax income, according to Investopedia; in other words, the money an investor chooses to invest into a Roth IRA must come from the investor’s net income, not gross income. A benefit of this is that the investor will not have to pay any taxes on the money upon withdrawing it in retirement.

An underlying requirement, however, is that only earned income can be added to a Roth IRA. Money considered earned income includes wages and salaries, bonuses, some stock sales, and even income earned via self-employment, according to Investopedia.

Additionally, there is no age limit for opening a Roth IRA, meaning that even children can open an account, provided that they have earned income — chores and allowance do not count. Roth IRAs also have contribution limits, depending on the investor’s age and annual income.

Investors who file their taxes single, not jointly with a spouse and earn less than $129,000 annually can contribute the maximum yearly amount to their Roth IRAs, which is $6,000 if they are under 50 and $7,000 if they are 50 or older, according to the IRS. For investors who file jointly with a spouse, or widows who meet specific qualifications, the income cutoff is $204,000 to be able to contribute the maximum annual amount, as per IRS guidelines.

When it comes to withdrawing money from a Roth IRA, there are certain guidelines and restrictions that investors should be aware of. If an investor withdraws any money from the account before the age of 59 and a half and before the account is over five years old, then the money withdrawn may be subject to penalties or fees, according to Charles Schwab.

The 401(k) account is another popular choice when it comes to opening retirement accounts. Unlike the Roth IRA, however, this retirement account is employer-sponsored, according to the Motley Fool. In other words, an investor would open this type of retirement account through his or her employer.

All employees that are over the age of 21 and have completed over 1,000 hours, or one year of work, for their companies are eligible to open a 401(k). A unique benefit of a 401(k) account is something known as an employer match, which is when an employer will match its employees’ contributions to their 401(k) accounts up to a certain value, according to Forbes.

Some employers might not offer an employer match, and others might offer modified programs where they might partially match their employees’ contributions. Investors should always take advantage of these programs if their companies offer them. But similar to Roth IRAs, 401(k) accounts have annual contribution limits; for 2022, the maximum yearly contribution to a 401(k) is $20,500 for all income levels, according to the IRS.

All contributions to a 401(k) account come from pre-tax, or gross income; this means that, unlike a Roth IRA, the investor does indeed need to pay taxes on the money in the account upon withdrawal. Additionally, just as it is with a Roth IRA, an investor can only withdraw money from a 401(k) after the age of 59 and a half; any withdrawals before this cutoff will be subject to a ten percent penalty, according to Experian.

So, when it comes to opening either one of these two retirement accounts, which one is more beneficial?

Well, for those who anticipate that they will be in a higher tax bracket when they retire than they currently are in, opening a Roth IRA might yield a better return because the investor does not pay any taxes upon withdrawing the money, but invests with after-tax income; in other words, the investor would effectively pay taxes while he or she is young, and in the lower tax bracket, and avoid paying taxes in a potentially higher tax bracket upon retirement.

On the other hand, for those who anticipate being in a lower tax bracket when they retire, a 401(k) would yield better returns because the investor would avoid paying taxes when he or she is earning money in a higher tax bracket and would pay them upon withdrawing the money in a lower tax bracket. A 401(k) would also be very beneficial in scenarios where the investor’s employer offers a solid employee match option.

Each person’s circumstances will vary, with some gaining more out of a Roth IRA account, and others gaining more from a 401(k) account.