Roth IRA vs 401k

Roth IRA vs 401k

13 min read

Here’s a topic that’s been coming up a LOT recently, and this is a highly confusing decision: What’s better to invest in, a Roth IRA or a Traditional 401k? Unfortunately, the answer isn’t as straightforward as you might like, but that’s okay. Here’s everything we know about the Roth IRA vs 401K. Hopefully, you can decide which one will work for you by this end. 

  • The main point of the Roth is its tax advantages. Roth IRAs offer tax-free growth of invested funds.
  • With a Roth IRA, you can only contribute POST TAX money
  • The 401k is an employer-sponsored retirement account where you CAN contribute PRE-TAX dollars, so you have more to invest upfront. 
  • Typically, an employer 401k requires mutual funds; this can make your 401k much less profitable than the Roth IRA.
  • You do not have to pick IRA over 401k. You can do both

So, let’s first start with some background on the Roth IRA.

401k

The Roth IRA

A Roth IRA is just a title given to an investment account. By calling it a Roth IRA, the IRS assumes that you will follow the rules they put forward for the Roth IRA. 

A Roth IRA is not much on its own; it’s just an account without anything inside it. Think of it like the shell of a house with no kitchen, flooring, furniture, nothing but walls and ceilings. So, likewise, to increase its value, we have to put stuff in it that has value. 

In a Roth IRA, you can put almost any investment inside the account. So, whether it’s stocks, bonds, mutual funds, gold, or real estate, you’re pretty much unlimited regarding what you can invest in a Roth IRA.

Think of this as finishing the house. When you add a kitchen, add some floors, a sofa, or a TV, now you suddenly have the potential for something to have real value. 

Roth IRA Details

The main point of the Roth is its tax advantages. Or the ability to withdraw with no taxes on the growth. There are no taxes on the contributions because you already paid taxes on the money before you put it in. So this could be years or decades of growth that can be withdrawn all tax-free—a significant distinction! 

How much can I contribute to a Roth IRA? Okay, so how much can you put in? Well, with a Roth IRA for 2021, most people can contribute up to $6,000. Alternatively, the limit is $7,000 if you are over fifty years old.

Pros of the Roth IRA

A. Tax-Free Investment Growth

First, as I mentioned above, all the money you make from your investments in this account is tax-free after you reach the age of 59.5. So, at this point, it’s safe to say with the right furnishings in your house, you can save a LOT of money by the time you retire, even more so if you start investing early. 

B. You Can Withdraw Contributed Funds Withdrawn Any Time 

Secondly, with a Roth IRA, you can withdraw the money you contribute to the account tax-free without paying any penalties. 

C. Choices

Another advantage of a Roth IRA is that you usually have more investment choices, including individual stocks, options, bonds, and mutual funds.

Cons of the Roth IRA

A. Money Invested Is After-Tax Income

Unfortunately, you can only contribute POST TAX MONEY with a Roth IRA. This means that the money you put in has already been taxed.

Sadly, as we all know, what’s left after the tax man’s taken his share is much smaller than what we had before. So, this means you’ll have LESS of your money to invest upfront.

B. Penalties For The Early Withdrawl Of Profits

Second, if you want to withdraw your profits from your investments before 59.5, you’re hit with a 10% penalty. You’ll also have to pay taxes on that profit based on your tax bracket. 

C. Yearly Contribution Limits

Third, the contribution limit for a Roth IRA is capped at $6000. So, if you want to contribute more than this, you can’t. 

D. Income Limitations

Once you make over a certain amount, you can’t contribute to a Roth anymore (there are some backdoor options). If you’re single and make $132,000 or more, or married and make $194,000 as a combined couple, you’re phased out from contributing to a Roth IRA. 

If you and your partner are on track to meet or exceed that income limitation, you might want to be sure you take advantage of the Roth IRA before it’s no longer an option.

E. Excess contributions to a Roth IRA can trigger excise taxes

Did you know that putting too much money into a Roth IRA can trigger excise taxes? The IRS will charge you a 6% excise tax on any extra money you put in your Roth IRA for each year it stays in the account. 

For example, your income exceeds the maximum limit, but you deposit $6,000 into a Roth IRA account. You could owe around $360 annually (plus 6% of your interest earnings on the $6,000).

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Roth IRA vs 401k to Avoid Excise Taxes

However, you can avoid excise taxes by either (A) withdrawing those contributions by the tax filing deadline, including extensions, or (B) applying the excess as a contribution to the following year. 

The current limit as of 2021 is now $6000/year for a single individual. So, if you were to contribute $8000 to a Roth IRA in 2021 by accident, you could withdraw $2000 before the April 15, 2022, deadline for filing the 2021 taxes. Or, apply the $2000 as contributions towards the $6000 limit of the 2022 tax year. 

There’s A Minimum Vesting Time

Distributions from a Roth IRA are only tax-free if:

  •  They have vested for at least five years, and
  •  You are at least 59 1/2 

If not, you must be disabled, or it’s distributed to a beneficiary/trust upon your death, or the amount is no greater than $10k and used to buy your first home. 

Early distributions are also subject to the additional 10% tax penalty for early withdrawals unless it qualifies for one of the exceptions. Therefore, I suggest you coordinate with the financial institution managing the Roth IRA so that they put Code-2 in Box#7 of the 1099-R. Otherwise, the distribution will have a Code-1 in Box#7 and be subject to the additional 10% tax. See IRS Pub 590-A and 590-B.

What Is the Traditional 401K?

Named after a section of the U.S. Internal Revenue Code, the 401 (k) plan is a retirement savings plan many employers in America offer. By signing up for a 401 (k), the employees agree to have a percentage of each paycheck paid directly into an investment account.

What’s unique with the traditional 401 (k) is that the money the employee puts in is pre-tax money! 

Pros of a Traditional 401k

A. You Contribute Pre-Tax Money

This is money you didn’t pay taxes on, so you can invest more. Also, it can be a huge tax deduction come income tax time as the employee’s taxable income is reduced by the total amount of money they contributed. Hence, they can be reported as a tax deduction for that tax year.

B. Higher Contribution Limits

Secondly, you can contribute up to $19,000 annually in a 401k compared to a Roth IRA. That’s more than THREE TIMES the Roth IRA contributions!

C. A 401k Employer Match

Third, some employers offer a 401k employer match. This means they match what you put in, dollar for dollar. An employer match is free money; how great is that?

D. First-Time Home Owner Benefits

Another benefit of a 401k is that the first-time home purchaser can take out $10,000 tax-free to apply to their new home. 

Cons of a Traditional 401k

A. Taxes Upon Withdrawl

Unfortunately, once you reach 59.5 and decide to start taking money out of your traditional 401k, you’re hit with taxes. With a 401k, you’re saving money on taxes NOW, so you have more to invest. 

However, With 401k, you can also avoid paying state taxes in states with no income tax. Later, you can move to states with no income tax. As of 2021, those states are Alaska, Florida, New Hampshire, South Dakota, Tennessee, Texas, Wyoming, and Washington. Food for thought.

B. Penalties For Early Withdrawl

Secondly, if you want to take the money out of your 401k before you hit 59.5, you’ll be subject to paying a 10% penalty. Further, based on your income tax bracket, you’ll owe more taxes on this money.

C. Forced Withdrawl At Age 70.5

Yes, you read that correctly. Once you hit the age of 70.5, the government forces you to begin withdrawing your money. And for those who prefer to continue saving it and letting it grow,…you can’t. 

Your requirement minimum distributions can also push you into a higher tax bracket, resulting in the taxation of Social Security

D. Lack of Diversification

I read that investment options in company 401k programs stink on ice. The investment options are far superior when your money is in a Roth or rollover IRA. Typically, an employer 401k requires mutual funds; this can make your 401k much less profitable than the Roth IRA.

What Happens to the 401K When You Leave That Job?

It is important to note that a 401k employer match is usually vested. Thus, you need to work with the same employer for X years to keep the match; otherwise, if you change companies, it’s forfeited.

If you’ve been there long enough, you can transfer the money into any IRA or retirement plan, and you won’t be penalized. However, you can take it out by check and then place it into another investment account; I think it’s 60 days.

So, how does all this info on the Roth IRA compare to the traditional 401k? The 401k is an employer-sponsored retirement account where you CAN contribute PRE-TAX dollars. Are the light bulbs going off in your head yet?

They should be because it means you have EVEN MORE money left over to invest. Remember, this is because you didn’t have to pay taxes on the money you contributed. So, the extra money you save can make YOU even more money! 

Which One Is the Best?

When analyzing the Roth IRA vs. 401k, one is easily left confused. So how does one decide which one is the best? In my opinion, the right mix is a balance between the two. 

 I think it is better to maximize the Roth IRA since stocks can generate a lot of growth tax-free. But, it would be best to match the employer contribution in a 401k. In addition, with the increased standard deductions, more people are getting more significant tax breaks regardless of whether they contribute pre or post-tax to retirement. For that reason, at least for now, Roth seems the way to go.

Roth IRA vs 401K: How to Use Both for Your Tax Advantage

1. Ensure you’re using a low-fee service (Vanguard/Fidelity)

2. Choose growth index funds and avoid value funds. Despite the name sounds nice, they have performed poorly over the last 13 years. 

3 Put money into the 401k up to the employer match

4. Max out Roth IRA (lock in low taxes at the moment if you are in a lower tax bracket or expect to be taxed higher in retirement)

 5. Max additional money into 401k. Or look into a Roth conversion i.e. backdoor Roth.

6. Invest as young as possible. $100 a month starting at age 18 will likely be $1 million by retirement due to compounding at historical average growth.

Before we end, it’s worthwhile to mention that some companies have a Roth 401k! 

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Employer Sponsored Roth 401k

Roth 401 (k) Plans An employer-sponsored Roth 401 (k) plan is similar to a traditional plan with one major exception. Contributions by employees are not tax-deferred; they are with after-tax dollars. However, income earned on the account from interest, dividends, or capital gains is tax-free.

Some companies have these accounts, and you can place the entire $19,000 post-tax. Also, there is no income limit on contributions to a ROTH 401k. With a ROTH IRA, you max out pretty quickly regarding income limits. If you elect to invest in a Roth 401k through your employer and they match a certain percentage, the amount they match will go into a traditional 401k. So you will end up with one Roth and one Traditional IRA that looks like just one combined account.

Also, in a traditional IRA, you must start taking money out when you’re 70 1/2. That is not the case with a Roth IRA. 

Two Dynamics of Roth IRA vs 401k

There are two dynamics at work here: the tax treatment of Traditional vs. Roth and the rules and limitations of IRAs versus 401ks (yes, there is such a thing as a Roth 401k, and most modern 401k plans today should offer that option). Also, you do not have to pick IRA over 401k; you can do both

For example, not all 401k plans allow access to purchase individual stocks. Suppose you roll over a considerable Roth 401k balance into a Roth IRA. In that case, there is a tremendous opportunity to position the portfolio to outperform the markets until retirement, subject to tax-free withdrawals. 

In all, if you have the option:

1) take advantage of the 401k and employer match benefits first

2) after getting the benefits, fund your IRA. 

3) If you can continue to save after maxing out the IRA, try to increase your 401k contributions beyond what is required for those employer benefits to max out the $19,000. 

If you switch employers, combine the 401k balance into your IRA, and you’ll have a much larger retirement account with maximum flexibility regarding investment options.

Final Thoughts: Roth IRA vs 401k

I think a better comparison would be Roth IRA vs. traditional IRA and Roth 401k vs. 401k. Given certain periods of your career, you can switch up the Roth versus Traditional contributions. Likewise, you can roll over the 401k balances into IRAs at a brokerage firm if you switch employers, allowing you to access higher-performing investment options to maximize your profits. 

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