Roth IRA vs 401k: who will win? Both plans enable a person to save and invest for retirement in a tax advantaged way. What does tax advantaged mean? That you pay less taxes!
An IRA is an individual retirement account. You can setup an IRA at various banks or a brokerage like Vanguard. A 401k is a retirement account setup through an employer. 401k retirement plans are named after section 401(k) of the Internal Revenue Code. Both 401ks and Roth IRAs allow a person to save for retirement and invest those savings, typically in mutual funds and bonds.
401k retirement plans are named after section 401(k) of the Internal Revenue Code
Roth IRA vs 401k which is better?
Everyone is in a different situation and so what is right for person A might not be right for person B. You should talk to a financial adviser to determine what is right for you.
Tax Benefits to Retirement Plans
401k contributions are made a pre-tax basis. Let’s say a single person under the age of 50 wanted to reduce their taxable income in 2019. This person has a 401k through their employer. A single person can contribute up to $19,000 to a 401k each year and that will reduce their taxable income by $19,000.
Social security and medicare taxes are still taken out of 401k contributions.
So if someone was making $90,000, they are in the 24% tax bracket, if they contribute $19,000 to a 401k, they would have a taxable income of $71,000 and would drop down to a 22% tax bracket. This is a simplified example with a lot of assumptions, but you get the idea.
Employers can also match an employees contributions up to a certain amount. For example, if the employer matches contributions up to 3% of an employee’s salary, they could effectively double their money saved just by putting it in a 401k.
A Roth IRA does not have the same tax benefits as a 401k. Contributions to a Roth IRA are done on an after-tax basis. So contributing to a Roth IRA will not reduce taxable income. A single person under the age of 50 can only contribute $6,000 to a Roth IRA each year.
In round one of Roth IRA vs 401k the 401k is looking better! But don’t call the fight yet.
There are various rules around withdrawing from both a 401k and IRA such as when money can be withdrawn without a penalty and when you must withdraw. I won’t get into all the details but the IRS requires 401k withdrawals upon achieving 70.5 years of age. These “Required Minimum Distributions” (RMDs) are taxed as ordinary income.
There are no required minimum distributions for Roth IRAs.
If a 401k had $200,000 in it, and the owner took out $100,000, it would be taxed as if they got a paycheck for $100,000 and they’d owe federal income taxes. Depending on the state, they might owe state income taxes as well.
This is where the Roth IRA has a decided edge versus the 401k. Since taxes were already paid on the Roth IRA contributions the withdrawals are tax free.
Conventional Wisdom: In Roth IRA vs 401k the Tax Advantages are Equal if the Tax Bracket does not change
3 November 2019: In a previous version of this article I stated, “If the tax brackets are the same during the contributions as withdrawals, the Roth IRA vs 401k tax benefits are identical.” I’ve come to realize this is not true.
I used to think, in accordance with conventional wisdom that if the tax brackets are the same during the contributions as withdrawals Roth IRA and 401k tax benefits are identical.
For example, say you have invested $10,000 into a 401k. The account appreciates 100% to $20,000 and then at retirement all $20,000 is withdrawn. The withdrawal is subject to a 20% income tax on it leaving $16,000.
Same scenario except this time the $10,000 is in a Roth IRA. The 20% income tax on the $10,000 is paid up front leaving $8,000 to invest which goes up 100% to $16,000.
However, this is only true when you assume that the loss of tax savings is taken out of the amount saved in a Roth IRA or 401(k). If the same amount is in both accounts the Roth IRA/401(k) is better.
What does John like better?
All else equal, in Roth IRA vs 401k I prefer a Roth IRA.
Why a Roth IRA?
First, because I think taxes are going up. If I pay taxes now, the rate will be lower than if I defer paying the taxes, and pay them later at a higher rate.
Even if tax rates do not go up I plan on making more money later in life than I am now. I’d rather pay the taxes now, than pay them later when I’m in higher income tax bracket.
High income earners are ineligible to contribute directly to a Roth IRA.
A typical employer provided 401k has very limited investment options. I’ve worked at several organizations over the years, and the investments were limited to a few US stock mutual funds, some bond funds, and some target retirement funds.
With a self-directed Roth IRA you can invest in mutual funds, stocks, bonds, options. In short there are many more investment choices available.
Plus with a Roth IRA you don’t have to deal with required minimum distributions.
Really not about Roth IRA vs 401k
In reality I contribute to both as I’m able. If my employer provides a 401k match, I will contribute to the 401k, until I max out that match, otherwise I’m just leaving money on the table.
Some employers also offer Roth 401ks, which can be great, depending on what your tax management goals are. There are also non-Roth IRAs, that work similarly to IRAs, in that they reduce your taxable income.
Tax situations can be complex, the above information is for educational purposes only.