401(k) vs. Roth IRA

In a perfect scenario, you might have a 401(k) and a Roth IRA to put aside funds for retirement, but if you are deciding between one or the other, here are some ways these types of accounts differ.

Roth IRAs and 401(k) accounts are popular tax-advantaged retirement savings vehicles that differ in tax treatment, investment options, and possible employer contributions. It is possible to contribute to both plans, but not with the same dollars. However, contributions from both accounts have to come from wages and other earned income, not investment or rental income.

Named after section 401(k) of the Internal Revenue Code, this retirement saving vehicle is an employer-sponsored deferred-income plan. To contribute to a 401(k), the employee designates a portion of each paycheck to be diverted into the plan. These contributions occur before income taxes are deducted from the paycheck.

The investment options among different 401(k) plans can vary tremendously, depending on the plan provider. But no matter which the fund (or funds) the employee chooses for his money, any investment gains realized within the plan are not taxed by the IRS. Taxation only occurs after the employee has reached retirement age and begins to make withdrawals from the plan. These distributions, as they're known, are subject to income taxes, at the retiree's 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.

As of 2019, the limit for annual 401(k) contributions for those under the age of 50 rises to $19,000 and those 50 and older can contribute an additional $6,000 per year in catch-up contributions.

To be sure, 401(k) plans are most beneficial when an employer offers a match, contributing additional money to the employee's 401(k) account – usually a percentage of the employee's contribution. This is a form of additional deferred income; it doesn't directly affect the employee's contribution. In 2019, the maximum annual contribution is $56,000 or $62,000 for those employees age 50 or older.

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

Since the account is set up and controlled by the account owner, investment choices are not limited to what is made available by a plan provider. This gives IRA accounts a greater degree of investment freedom than employees have with 401(k) plans. There are quite a few brokers who provide individual retirement accounts. If you're looking into opening an account like this, Investopedia has created a list of the best brokers for IRAs to make that process easier for you.  

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

The contribution limits are much smaller with Roth IRA accounts. In 2019, the maximum annual contribution for those under the age of 50 is $6,000, up from $5,500 in 2018. Those age 50 and up can contribute an additional $1,000 for a total of $7,000/$6,500 per year.

Individuals who earn more than $137,000 per year in 2019 ($135,000 for 2018) – or $203,000/$199,000 for those married filing jointly – are ineligible to contribute. Below those limits, there is a phase-out income group for whom partial contributions are possible. The range for 2019 is $122,000 to $137,000 for individuals and $193,000-$203,000 for those married filing jointly.

Roth accounts make the most sense for individuals who believe that they will be in a higher income tax bracket when they retire. Obviously, it's better to pay taxes on a smaller percentage of your income prior to contributing (as in a Roth IRA) than to pay a larger percentage of taxes on withdrawals (as in a 401(k) or traditional IRA).

A Roth IRA has a five-year rule when it comes to accessing your earnings. While you can withdraw your contributions at any time or any age, you must have held the account for five years in order to access the earnings and contributions together. The five-year rule states that you cannot withdraw your earnings for five years from the first tax year of your original contribution to the account. When you turn age 59½ you can access both your earnings and contributions without penalty or paying taxes, if you have followed the five-year rule.

If your employer offers a 401(k) matching program, it is a great opportunity to save even more retirement dollars. A Roth IRA does not offer the same type of benefit, as it is an individually owned account. If you believe you are going to be in a higher income bracket in retirement, a Roth IRA may make the most sense. Ideally, having both a 401(k) and a Roth IRA (provided you can afford to fund both) will present the most opportunities for a well-funded retirement.