When is a Roth IRA Better Than a 401(k)?

A Roth IRA and a 401(k) are both investment vehicles for retirement, designed to ensure financial protection and steady pay in the owner’s golden years. Most people are familiar with a 401(k) because they are employed and their employer sponsors it but not everyone knows what a Roth IRA is. Both have advantages and knowing what those advantages are will empower you to take control of your retirement investing. By the end of this though, you should have a much better understanding of when a Roth IRA is better than 401(k).

If you want to see in a quick glance, the following chart should help. It’ll be explained in much better detail below.

Roth IRA vs 401(k) Quick Reference

Account Type 401(k)Roth IRA
Contribution Limts$19,500 (as of 2020)$6,500 total (as of 2020)
Taxed ContributionsNoYes
Taxed WithdrawalsYesNo
Age of Allowable Distribution59 1/2Any (prior to 59 1/2 will pay taxes on earned income only)
Penalty for Early Distribution (prior to age 59 1/2)YesNo
Age Contributions Must Stop70 1/2None
Age Distributions Must Be Made70 1/2None

What’s a 401(k)?

retirement plan from work

A 401(k) is an employer-sponsored retirement investing plan. You can invest a percentage or fixed amount of your pay each paycheck and watch it grow over time so that when you retire, you have a nest egg to support you during this later part of your life. One of the major features of a 401(k) is that you are making your investment contribution from your income prior to having taxes applied. For example, if you make $2000 every paycheck and contribute $200 every paycheck, your contribution will be tax-free and taxes will be applied to the remainder of $1800.

401(k) gets its name from the subsection of the IRS CodeOpens in a new tab. that discusses retirement plans. You do have some control generally on how your contribution is allocated but every plan is different. Basically, it is invested in a blend of mutual funds.

One reason 401(k)s are popular is that employers can sometimes provide additional benefits to employees by matching their contributions. Sometimes they will match up to a certain percentage of pay that is contributed. In fact, employers can get creative and match contributions through a tiered system as well. If you have a 401(k), it’s essential to know what your employer’s policy is for matching contributions. Taking advantage of their max contribution match is like getting free money on top of your current salary or pay.

What’s a Roth IRA?

A Roth IRA (Individual Retirement Arrangement) is a retirement plan that you can open with any brokerage. Most commonly; however, it’s known as an Individual Retirement Account. Since it’s an individual tailored plan, you have complete control of it and your employer has no interaction with it. This is for you to take your retirement into your own hands. The Roth IRA gets its name from Senator William RothOpens in a new tab. who sponsored the legislation that introduced the Roth IRA.

What makes an account a “Roth” IRA means that you will make your contributions after taxes have been applied to your account. As a result, when you are ready to retire (age 59 1/2 or older), you will be able to withdraw from a Roth IRA without having to pay taxes on it. It’s all tax-free because you paid the taxes earlier in life. I like to think of it as Younger You taking care of Uncle Sam so Older You doesn’t have to!

Now that you know what a 401(k) and a Roth IRA are, let’s go over the advantages and disadvantages of both so you can decide whether a Roth IRA is better than a 401(k) for you or if it has a place alongside your 401(k).

Advantages of a 401(k)

  1. High Contribution Limits – All retirement plans have annual limits for what can be deferred. Traditional 401(k) plans allow you as the employee to contribute up to $19,000 each year for 2019 ($19,500 for 2020). Employer match contributions do not count against this.
  2. Employer Match Contributions – Almost all employers will match an employee’s contributions based on a percentage of the employee’s salary. Employers are limited to 6% matched contributions but this is basically free money on top of your salary. If you contribute 6% and your employer matches the 6%, that doubles the amount you are investing for retirement which is effectively getting a 6% raise from your employer.
  3. Lower taxes – Since you are investing part of your pay into your tax-deferred 401(k), the amount you are contributing is not taxed that year. You will only be taxed on your pay after the contribution is made.

Disadvantages of a 401(k)

  1. Taxes on withdrawal – The tax man will still come eventually. Once you reach retirement (at least age 59 1/2), you will be taxed on the income you make based on your 401(k) withdrawals. If you weren’t factoring taxes in during retirement, this can be a significant burden that was not anticipated.
  2. Early Distribution Penalty – If you need to access your funds before you reach retirement (age 59 1/2), you will have to pay a fee on the amount that you withdraw. This is known as an “early distribution penalty tax” and can cost you 10% of the amount you withdraw.
  3. Waiting Periods – Employers can actually require a waiting period before employees are given the opportunity to contribute to an employer-sponsored 401(k). A typical wait period is 6 months but this can actually drag out for a year. This waiting period reduces your ability to save for your retirement and can set back projections causing employees to contribute more to “catch up” when the opportunity arises.

Advantages of a Roth IRA

  1. No Taxes on Withdrawal – Since you paid the taxes for your Roth IRA on your pay prior to contributing to your Roth account, it will be withdrawn during retirement with nothing due to Uncle Sam. This is the biggest advantage of the Roth IRA.
  2. You can withdraw early without penalties – Even though this is a retirement account, you can withdraw your contributions at any time without paying taxes or penalties. This can be a huge benefit for people when LIFE happens and you need some extra money in a pinch. The only thing to be mindful of is that you may have to pay taxes on the earnings you’ve made if you don’t make certain criteria which you can find hereOpens in a new tab.. Still, it’s a small price to pay when you need some extra income in an emergency.
  3. You can make contributions after you turn 70 1/2 – Traditional IRAs require you to take mandatory minimum withdrawals after you turn 70 1/2. With a Roth IRA, not only are mandatory withdrawals not required, but you can also still make contributions. In fact, you can contribute to your Roth IRA at any age.

Disadvantages of a Roth IRA

  1. Low Contribution Limits – You are only allowed to invest up to $5,500 for 2019 ($6,500 for 2020) between Traditional AND Roth IRAs. So if you have multiple accounts, they can not exceed this amount when added together. For Roth IRAs you may be limited to further based on your Adjusted Gross Income. You can see if this is the case, by checking here for 2019Opens in a new tab. or 2020Opens in a new tab..
  2. No Employer Match – You are investing in your own future but since this is your individual account, your employer will not be matching any of your contributions.
  3. You will pay taxes upfront – After your income is taxed, your contribution will be added to your Roth IRA. For the year you are contributing, there is no tax benefit using a Roth IRA.

When Is a Roth IRA Better Than a 401(k)?

Reviewing the advantages and disadvantages above should help you answer this for yourself. Ask yourself these following questions and if you answer yes, a Roth may better a better option for you:

  • Do you believe you will pay fewer taxes today than when you would retire and withdraw from your retirement fund?
  • Do you like the flexibility to withdraw from your fund in an emergency without having to pay taxes or penalties?
  • Do you want to be able to make contributions at any age?
  • Do you want to have the option to let your retirement fund grow past 59 1/2 without being required to make scheduled minimum withdrawals?

If you answered yes to any of those questions, having a Roth IRA will satisfy you but before you change your contributions from your 401(k) to a Roth IRA, read below!

You Don’t Have to Give up One for the Other

you can choose both

You don’t need to only have one type of retirement vehicle. You can contribute to a 401(k) and to a Roth IRA if you desire. Depending on how much you are willing to contribute to retirement, you may actually need to since the Roth IRA has a maximum contribution of $6,500 for 2020. If you wanted to contribute $10,000 to retirement each year, you would have to have two different types of retirement since all IRA contributions are limited to that same $6,500 limit.

Also, don’t lose sight of the free money that your employer offers if they do offer to match contributions. You should at least invest enough in a 401(k) to benefit from the maximum contributions that an employer matches. Like mentioned earlier, this is free money and to not take advantage of your employer-sponsored matches is like throwing money away!

If you really like the opportunities that arise from a Roth IRA, I would recommend contributing to your 401(k) enough to get the matching contributions, and then any additional money that you want to contribute to retirement send to a Roth IRA.

Where to Open a Roth IRA Account

You can find Roth IRAs at just about any major stock brokerage or bank. If you want to keep all of your financial eggs in one basket, you can ask your current bank if they offer IRAs. If you want to open up a completely separate account though, you can reach out to every reputable brokerage.

Webull offers you a bonus for opening an account with them that ranges up to $1,500 depending on how much you contribute initially. You can read all about Webull at our full review of Webull.

If you already belong to a brokerage for trading in the stock market, they almost certainly have IRAs as well. Either way, there are plenty of places to open up a Roth IRA that will meet your financial plan. I hope this article helps you better understand how Roth IRAs work and how they differ from a 401(k). You should be able to decide if it is a better option than a 401(k) or a compliment alongside your current plan.

Let me know below which of these you prefer or if you’re using both! Also, if you have questions, thrown them below as well.

Now, Let’s Start Investing!

Eric Baglio

Eric Baglio has been investing for over ten years and learned a lot of valuable lessons along the way. He has helped numerous people start investing on their own and founded Let's Start Investing to help anyone willing to learn how to build wealth. His favorite brokerage is Webull and his favorite stock advising service is Motley Fool Stock Advisor.

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