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401(k) vs. Roth IRA: An Overview

Both 401(k)s and Roth IRAs are popular tax-advantaged retirement savings accounts that differ in tax treatment, investment options, and employer contributions. Both accounts allow your savings to grow tax-free.

Contributions to a 401(k) are pre-tax, meaning they are deposited before your income taxes are deducted from your paycheck. However, when in retirement, withdrawals are taxed at your then-current income tax rate. Conversely, there is no tax savings or deduction for contributions to a Roth IRA. However, the contributions can be withdrawn tax-free when in retirement.

In a perfect scenario, you’d have both in which to put aside funds for retirement. However, before you decide, there are several rules, income and contribution limits that investors should be aware of before deciding which retirement account works best for them.

Key Takeaways

  • Both 401(k)s and Roth IRAs allow your savings to grow tax-free.
  • Many employers offer a 401(k) match, which matches your contributions up to a specific percentage of your income.
  • Contributions to a 401(k) are pre-tax, meaning it reduces your income before your taxes are withdrawn from your paycheck.
  • Conversely, there is no tax deduction for contributions to a Roth IRA, but contributions can be withdrawn tax-free in retirement.
  • Retirement distributions from 401(k)s are taxed at your-then income tax rate.

401(k)

Named after section 401(k) of the Internal Revenue Code, a 401(k) is an employer-sponsored retirement plan. To contribute to a 401(k), you designate a portion of each paycheck to divert into the plan. These contributions occur before income taxes are deducted from your paycheck.

The investment options among different 401(k) plans can vary tremendously, depending on the plan provider. Typically, plans offer a mix of mutual funds and exchange traded funds, which contain a basket of securities or stocks. Nevertheless, no matter which fund (or funds) you choose, any investment gains realized within the plan are not taxed by the Internal Revenue Service (IRS).

Investment gains you make within your 401(k) are never taxed by the IRS.

401(k) Contribution Limits

Notably, 401(k)s have much higher contribution limits than Roth IRAs. For 2020 and 2021, the annual 401(k) contributions limits are the same.

The contribution limits are as follows:

  • $19,500 if you’re under age 50
  • $26,000, which includes an allowance for a catch-up contribution of an extra $6,500 if you’re age 50 or older

401(k) Employer Match

Overall, 401(k) plans are most beneficial when your employer offers a match, contributing additional money to your 401(k) account. The match is usually a percentage of your contribution, up to a certain percentage of your salary.

For example, your employer might match 50% of your contributions, up to 6% of your salary. The employer match doesn’t count toward your contribution limit, but the IRS does cap the total amount that can go into your 401(k) each year (your contributions plus the match).

For 2020 and 2021, the combined contribution limits for a 401(k) are as follows:

2020

  • $57,000 in total contributions if you’re under age 50
  • $63,500 if you’re age 50 or older, including the $6,500 catch-up contribution
  • 100% of your salary (if it’s less than the dollar limits)

2021

  • $58,000 in total contributions if you’re under age 50
  • $64,500 if you’re age 50 or older, including the $6,500 catch-up contribution
  • 100% of your salary (if it’s less than the dollar limits)

401(k) and Taxes

You get a tax break when you contribute to a 401(k). That's because you can deduct your contributions when you file your income tax return. This reduces your taxable income, which can save you money.

You’ll pay taxes after you reach retirement age and begin to make withdrawals from the plan. These withdrawals are called distributions and are subject to income taxes at your then-current tax rate. If you think your income will be higher when you retire, you may want to plan ahead, as all income from your distributions will be taxed.

401(k) Required Minimum Distributions

If you have a 401(k), you have to start taking required minimum distributions (RMDs). Your RMD is the minimum amount that must be withdrawn each year from your IRA account when you're in retirement. In other words, you can't leave all of your money in an IRA; otherwise, there'll be a 50% tax penalty on the amounts of the RMD that was not withdrawn. You must begin taking required minimum distributions RMDs by April 1 of the year following the year you turn 72 or the year you retire, whichever is later.

Here’s a quick look at the pros and cons of 401(k) plans.

Pros

  • Employer match

  • Higher contribution limits

  • Maintained by employer

Cons

  • Fewer investment options

  • Required minimum distributions

  • Higher fees

Roth IRA

A variation of traditional individual retirement accounts (IRAs), a Roth IRA is set up directly between an individual and an investment firm. Your employer is not involved.

As you set up and control the account, your investment choices aren’t limited to what the plan provider offers. This gives IRA holders a greater degree of investment freedom than employees have with 401(k) plans, even though the fees charged by those providers are typically higher.

In contrast to the 401(k), after-tax money is used to fund a Roth IRA, meaning you get no tax deduction in the years you make contributions or deposits. As a result, no income taxes are levied on withdrawals during retirement. While in the account, any investment gains are untaxed.

Roth IRA Contribution Limits

The contribution limits are much smaller with Roth IRA accounts. For 2020 and 2021, the maximum annual contribution for a Roth IRA is:

  • $6,000 if you’re under age 50
  • $7,000 if you’re age 50 or older, which includes a $1,000 catch-up contribution

Roth IRA Income Limits

The Roth IRA income limits are different for 2020 versus 2021. How much you can contribute to a Roth IRA depends, in part, on how much you earned in that year. In other words, the contribution amount allowed can be reduced, or phased out, until it's eliminated, depending on your income and filing status for your taxes (i.e. single or married).

2020

For individuals filing taxes as single, you can make a full contribution to a Roth if your income is less than $124,000. Your contributions will be reduced or phased out if your income is between $124,000 and $139,000. If you earn more than $139,000, you cannot make any contributions to a Roth IRA.

If you're married filing jointly, you can make a full contribution to a Roth if your income is less than $196,000. Your contributions will be reduced or phased out if your income is between $196,000 and $206,000. If you earn more than these IRS-imposed limits, you can’t contribute to a Roth IRA.

2021

For individuals with a tax filing status of single, you can make a full contribution if your income is below $125,000. The income phase-out range has been increased to $125,000 to $140,000.

If you're a married couple filing jointly, for 2021, full contributions are allowed if you make less than $198,000, while the income phase-out range is $198,000 to $208,000.

Roth IRA Withdrawals

You can withdraw your Roth IRA contributions at any time or any age with no tax or penalty. Withdrawals on earnings, however, could be subject to income taxes and a 10% penalty, depending on your age and how long you’ve had the account.

In general, you can avoid taxes and the penalty if your account is at least five years old and the withdrawal is:

If you don’t meet those guidelines, you may be able to avoid the penalty (but not the tax) if a qualified exception applies.

Unlike 401(k)s, Roth IRAs have no RMDs during your lifetime. If you don’t need the money in retirement, you can leave it in the account, where it can continue to grow tax-free for your beneficiaries.

Below is a rundown of the pros and cons of Roth IRAs.

Pros

  • Withdrawals are tax-free in retirement

  • More investment choices

  • No RMDs during your lifetime

Cons

  • Lower contribution limits

  • Income limits can prevent you from contributing

  • No employer match

Key Differences

Here’s a rundown of the differences between 401(k)s and Roth IRAs.

401(k)s vs. Roth IRAs
Feature 401(k) Roth IRA
Upfront tax break Yes. Contributions are deductible. No
Withdrawals Taxed as ordinary income Tax-free
Contribution Limits $19,500, or $26,000 if you’re age 50 or over $6,000, or $7,000 if you’re age 50 or over
Income Limits No Yes. At higher incomes contributions are reduced or eliminated.
Employer Match Yes. There’s a $57,000 ($63,500 for age 50 or over) limit on combined employer/employee contributions in 2020. For 2021, the combined limits are $58,000 ($64,500 for age 50 or over). No
Automatic Payroll Deduction Yes No
Earliest age to withdraw funds without penalty 59½ Withdraw contributions at any time, earnings at 59½
RMDs Yes. RMDs must start by April 1 following the later of the year you reach age 72 or the year you retire. Not during the owner’s lifetime
Average Fees High Low
Investment choices Few Many
Maintained By Employer Self

In many cases, a Roth IRA can be a better choice than a 401(k) retirement plan, as it offers a flexible investment vehicle with greater tax benefits—especially if you think you’ll be in a higher tax bracket later on. However, if your income is too high to contribute to a Roth, your employer offers a match, and you want to stash more money each year, a 401(k) is hard to beat.

A good strategy (if you can manage it) is to have both a 401(k) and a Roth IRA. Invest in your 401(k) up to the matching limit, then fund a Roth up to the contribution limit. After that, any leftover funds can go toward your 401(k)’s contribution limit.

Still, everyone’s financial situation is different, so it pays to do your homework before making any decisions. When in doubt, speak with a qualified financial planner who can answer any questions and help you make the right choice for your situation.