Roth IRA vs 401(k)? You May Not Have to Choose

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One of the most common retirement questions I get asked is: Roth IRA or 401(k)?

Although both are good options worth considering, the answer isn’t always as straightforward as one might think. What’s more, it’s important to realize that you may not even need to pick one or the other. If you’re able to contribute to a work-sponsored 401(k), there’s no reason you can’t also contribute to a Roth IRA, provided you meet certain conditions.

Before we delve deeper into this debate, though, let’s first make sure we have a working understanding of each of these tax-advantaged retirement options.

What Is a 401(k)?

A 401(k) is an employer-sponsored deferred contribution retirement plan, so named because it’s defined under section 401(k) of the IRS code. In a nutshell, it works like this: You sign up for a 401(k) plan in your workplace and choose investment options within the plan. Your workplace takes money out of your paycheck before income taxes are taken out and deposits this in your plan. In some workplaces, your contributions are matched by the employer.

Then, when you reach retirement age, you can take money out of the 401(k), but those withdrawals are subject to income tax – since you didn’t pay tax on the money the first time around, you have to pay it later on. (The benefit of the deferred tax structure is based on the assumption that you’ll be in a lower tax bracket in retirement compared to your prime earning years.)

Currently, there is no upper income limit on who can contribute to a 401(k), but an individual can contribute a maximum of $19,000 to his or her 401(k) in 2019, and the maximum total amount that can be contributed between employer and employee is $56,000 in the same year.

Benefits of a 401(k)

  • Your contributions may result in tax savings during each year you contribute.
  • Your employer may offer a company match — a.k.a. free money.
  • In most cases, the money you contribute can be taken directly out of your paycheck before it reaches your checking account. Out of sight, out of mind.
  • You can contribute a lot more each calendar year using this option (up to $19,000 per year in 2019) compared to a Roth IRA.

What Is a Roth IRA?

A Roth IRA is a type of independent individual retirement account that you set up directly with an investment firm. Its name comes from its chief legislative sponsor, Senator William Roth.

With a Roth IRA, you can set up an account with any investment firm or online brokerage, choose investment options with them, and then directly deposit after-tax money (from your checking account, for example) into the Roth IRA. Then, when you meet a few basic requirements (once you’re 59-1/2 years old, and have had the plan for at least five years), you can withdraw both your deposits and investment gains completely tax-free. You can also withdraw funds penalty-free to pay for a child’s education or a down payment on your first house.

In 2019, the maximum contribution you could make to a Roth IRA is $6,000 a year (unless you’re over 50, in which case you can make an additional $1,000 “catch-up” contribution). However, there is one big caveat: There are income limits on who can contribute. If you make more than $120,000 individually or $189,000 jointly, you can’t contribute the full amount (and may not be able to contribute at all). For more details, check out our post on income and contribution limits for Roth IRAs.

Roth IRA Benefits

  • Your eventual withdrawals will be tax-free since you funded your account with after-tax dollars.
  • You can actually withdraw your contributions at any time, for any reason, without penalty. (You cannot begin withdrawing your investment earnings before age 59-1/2 without incurring a penalty.)
  • Unlike with a work-sponsored 401(k), your Roth IRA will allow you to pick and choose a brokerage firm and your individual investment options.

Roth IRA vs 401(k): What Are the Major Differences?

The big differences between a Roth IRA and 401(k) are eligiblity, employer contributions, investment options, and tax breaks. Let’s look at each aspect.

Eligibility, Income, and Contribution Limits

While anyone earning less than $120,000 a year (or $189,000 for married couples) in 2019 can contribute up to $6,000 to a Roth IRA, eligibility phases out at higher incomes. There’s no upper income limit on a 401(k), meanwhile, and contribution limits are much higher, at $19,000 plus employer contributions.

However, not everyone is able to participate in a 401(k); in fact, more than a third of Americans don’t have access to such a plan at work.

Advantage: Depends on your income and employer benefits

Employer Contributions

With a 401(k) retirement plan, an employer may match contributions made by an employee up to a certain percentage. For example, let’s say you contribute 10% of your gross salary to your work-sponsored 401(k). In some cases, your employer will match your contributions up to a certain percentage, usually somewhere between 3% to 6%.

When your employer offers a perk like this, it’s crucial that you take advantage of it. It’s free money, after all – don’t turn it down. In a nutshell, employer contributions are also one of the advantages of using a 401(k) in the first place. While a few companies actually offer a Roth-style 401(k), a Roth IRA is funded only with your after-tax dollars, which means you won’t receive this benefit with a Roth IRA.

Advantage: 401(k)

Investment Options/Management

Although receiving an employer match when you use your 401(k) can be rather attractive, that doesn’t mean that using that particular type of retirement account doesn’t come with its own set of drawbacks. With a 401(k), you’re tied into whatever management and investment options are made available to you by the plan your company offers. In some cases, that means that your choices could be rather sparse and not all that great, although that isn’t always the case.

Important items to look out for in your investment plans are fees, expense ratios, and investment options. The best employer plans will have low expenses and as many options as possible.

With a Roth IRA, you have a lot more control over those variables – you pick the brokerage you want to use, and are free to choose from their investment options. Roth IRAs offer an advantage in that they allow you to choose your plan’s manager, though if your 401(k) offers good options, this may not be a big advantage.

Advantage: Roth IRA

Tax Breaks

Another big difference between a 401(k) and a Roth IRA is the way taxes are paid on both your contributions and your withdrawals. In short, your 401(k) plan is funded with pre-tax dollars, which can be beneficial since it reduces your tax liability during each year you contribute — often in the prime of your career, when you may be in a higher tax bracket. This might allow you to invest more and sooner than you otherwise could, giving that money more time to grow for you. However, when you eventually take that money out of your 401(k) in retirement, it will be taxed as ordinary income.

Meanwhile, a Roth IRA works in almost the exact opposite way. The money you contribute has already been taxed, which means that making a Roth contribution won’t affect your taxable income in the year you contribute. However, since you’ve already been taxed on your contributions, you won’t need to pay taxes when you begin withdrawing funds in retirement. That also means you can withdraw any investment earnings within your account tax-free.

Advantage: It depends on your tax rates

How can you know which rate will be higher? Here are a few things to ask yourself.

Will my income increase between now and retirement? If the answer is yes, you’ll likely be in a higher tax bracket when you retire, which favors the Roth IRA. If you’re near your peak earning years, you’ll probably be in the same bracket or lower, which favors the 401(k).

Will I be working in my retirement years? If the answer is yes, you have a much higher chance of at least being in the same tax bracket you’re in now.

Will the political landscape shift towards higher tax rates? This one, honestly, is complete guesswork. If I had to guess, I would speculate that tax rates will go up in the future. If that’s the case, you might want to lean towards a Roth IRA since your future distributions will be tax-free, no matter what happens with the tax code. If you expect to pay a lower tax rate in the future, however, a 401(k) funded with pre-tax money might be a better bet since you won’t be taxed on that money until you retire and begin taking distributions.

Best Strategies for Maximizing Your 401(k) or Roth IRA Contributions

Contributing to at least one type of retirement account faithfully is crucial if you ever hope to retire. In most cases, Social Security funds will not be enough to sustain you, and your cash savings probably won’t have the opportunity to grow the way they would if you had invested that money all along.

When it comes to picking between a Roth IRA and 401(k), there really is no perfect answer. Your individual situation will impact which plan works best for you, and even then, there are several different ways to look at it.

It’s also important to note that you don’t have to pick one type of account over the other. You can contribute up to $19,000 to your 401(k) and put up to $6,000 in a Roth IRA or traditional IRA that same year. Here are a few different strategies you might want to consider as you move forward.

Max out your 401(k) and contribute to a Roth.

If your work-sponsored 401(k) offers low fees, plenty of options, and an employer match on your contributions, you might want to max out for your 401(K) and contribute to a Roth IRA. This is a great strategy for anyone who has extra money to invest and wants to lower their tax liability.

Contribute to your 401(k) up to the company match, then begin funding your Roth IRA.

If your work-sponsored 401(k) doesn’t come with the best options but you still want to take advantage of your company match, you could always contribute a percentage equal to what your employer has pledged to contribute, then focus on contributing anything else to your Roth IRA. Young people especially should consider the future benefits of a Roth IRA since many experts agree that tax rates could go up significantly over the next few decades.

Contribute a set amount to each type of account each month.

If you’re struggling to decide which type of account will benefit you in the long run, you might just want to split the difference and contribute equal dollars to both. Set up your 401(k) contributions to include a percentage of your income that you can easily match in your Roth IRA. Then make a commitment to invest every month, no matter what.

Best Roth IRA Providers

Using a 401(k) means making the best of the investment options and brokerage firm your employer has chosen for you. However, with a Roth IRA, you’re on your own to make this important decision.

Fortunately, several online firms offer an array of financial services that include Roth IRA set-up and management. Here are a few of the best online options, as well as a basic rundown of what each has to offer.

TD Ameritrade

When it comes to online brokerage firms, TD Ameritrade is known for low priced trades and quality customer service. There’s a reason over 11 million people hold accounts with TD Ameritrade. Founded in 1975, the company has proven itself over the years by offering excellent customer service, investment professionals you can count on, and competitive fees. Since acquiring popular discount broker Scottrade in 2017, TD Ameritrade charges a low $6.95 fee for trades, while continuing to offer perks like the opportunity to speak with a financial advisor for free during one no-obligation consultation.

Benefits of TD Ameritrade

  • Streaming quotes: Unlike many other online brokerage accounts, TD Ameritrade doesn’t make you pay extra to see streaming quotes from day one. You simply need to open an account and fill out a few forms to gain access.
  • Low fees and no hidden charges: Beyond the $6.95 flat unlimited trade fee, you can also use TD Ameritrade without worrying about hidden fees or charges.
  • Plenty of investment options: With TD Ameritrade, you can choose to invest in everything from stocks to mutual funds and banking products. Their mutual fund offerings alone give you more than 13,000 options to choose from.
  • Excellent support and customer service: TD Ameritrade customer support is available 24/7.
  • One of the best trading platforms in the business: Unlike other brokerage firms with somewhat basic trading platforms, TD Ameritrade is known for its superior trading platform and powerful research tools.
  • No minimums: With TD Ameritrade, there is no minimum opening deposit.
  • Local branches: TD Ameritrade also offers convenient local branches for more personalized service.

E*TRADE

As one of the first brokerage firms to go online,E*TRADE is one of the most established and trusted of the bunch. All E*TRADE customers have access to streaming stock quotes, various financial and investment tools, and below-average account minimums. Investors who make 30 or more trades per quarter also qualify for a low $4.95 commission rate, while investors who make more trades often qualify for even lower rates. Meanwhile, E*TRADE also offers many commission-free ETFs, as well as mobile access, 24/7 customer service, and some physical branches. Beyond those basics, here are some of the major benefits that come with choosing E*TRADE:

Benefits of E*TRADE:

  • Plenty of investment options: With E*TRADE, you’ll have access to over 8,000 mutual funds, 1,300 of which come with no load and no transactions fees. In addition, you’ll also have access to forex/future trading, which isn’t always available with other online firms.
  • Low account minimums: To open an account with E*TRADE, the account minimum is only $500 (or $2,000 for a margin-enabled account).
  • Excellent trading tools: Beyond their basic trading platform, E*TRADE also goes out of its way to ensure maximum trader education with powerful trading and research tools available to all users.

Betterment

Betterment is among the many robo-advisors that have sprung up in the past few years, which aim to simplify investing through low-cost, sophisticated automation.

To cut down on fees, Betterment uses low-cost exchange-traded funds, or ETFs, which are similar to mutual funds but can be traded like stocks. In addition, Betterment offers a ton of comprehensive wealth management features that many of the stock trading firms do not, such as automated portfolio rebalancing, tax-loss harvesting, and automatic dividend reinvestment.

Choosing the Right 401(k) or Roth IRA Option

Whether you’re choosing between a 401(k) or Roth IRA, or simply trying to choose which brokerage firm you want to use to make trades or manage your investments, it’s important to remember that there’s never a one-size-fits-all option. To figure out what’s best for you, you have to explore all of the pros and cons with each opportunity and figure out how they relate to your own situation.

The most important thing to remember is that, in most cases, time is on your side. The earlier you start investing and saving for retirement, the better off you’ll be, and the most important step is simply getting started. So take time to choose which type of retirement options is best for you, but don’t let having too many options deter you from making a decision altogether.

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