Roth IRA vs. 401k How to Decide

Deciding whether a Roth IRA or a 401k is the better retirement account depends on your own unique situation. There is no one-size-fits-all solution for which type of retirement account is more advantageous to every person. The primary differences between the Roth IRA and the 401k plan is when you pay taxes on the contributions, and whether you are eligible for the accounts or not – and these differences can help you decide which account is best for you.

Roth IRA vs. 401k How to Decide

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Roth IRA Eligibility Requirements

Not everyone is eligible to contribute to a Roth IRA. Single tax filers making more than $95,000 annually are ineligible to open a Roth IRA. Married tax filers with combined annual incomes of $150,000 or more cannot invest with Roth IRAs. If your income is too high for the Roth IRA, you have to choose another type of retirement account, like the 401k.

401k Eligibility Requirements

The employer sponsoring the 401k plan typically sets their own eligibility requirements for employees. Usually, the requirements are such that the investor must be at least 21 years of age and have at least one year of service with the company to become eligible for contributing.

Taxes and the Roth IRA

When you contribute to a Roth IRA, you pay taxes on the money before it is deposited. When the money compounds and grows over time, there are no new taxes added. When you withdraw the money and earnings from the contributions, you are not taxed a second time.

Taxes and the 401k

When you contribute money to a 401(k) plan, it is done with pre-tax dollars. The money is typically taken from your pay before you even see it, and deposited into the 401k plan. Your contributions will earn tax-free while still in the account, but when you withdraw the money you pay ordinary income tax on the contributions and the earnings made.

Which Retirement Account is Better?

Choosing between the two retirement accounts depends on your situation. Do you think there is a good chance you won’t need the money you save in a Roth IRA? If so, the Roth has an advantage over the 401k in that you are not required to take distributions from the Roth IRA. This makes it a nice way to pass money to your children or other heirs. The 401k requires that you begin taking distributions at the age of 70 and a half.

If you plan on using the money in your retirement account yourself, as most people do, then you need to decide whether you think your tax rate will be higher when you contribute to the fund or higher when you take withdrawals from the fund. If you think you’ll be in a higher income tax bracket when you retire than you are now; the Roth IRA is a good choice because you pay the taxes now at your current, lower tax rate.

If on the other hand, you expect to decrease income and downsize during retirement and spend more money during retirement, you might find your tax rate is lower than it is now. If this sounds more like you, the 401k is probably a better option since you’ll be paying taxes when the money is withdrawn and while you’re in a lower tax bracket.

Another consideration when choosing between a Roth IRA and a 401k retirement account is whether or not you think you will need access to the money before you retire. Because you pay taxes on contributions to a Roth IRA, you can withdraw money you contributed (not the earnings it made) at any time without penalty. Withdrawing money from a 401k plan, while possible, results in costly early-withdrawal penalties and tax penalties.

Should You Have Both a Roth IRA and a 401k?

In some cases, it makes sense to have both a Roth IRA and 401k plan. Because a Roth IRA is not associated with any employer, you don’t have to worry about transferring the funds to another account if you should lose or change jobs. If your current employer offers 401k plan matching, however, you don’t want to miss out on the free money! Contribute at least as much as your employer will match to your 401k plan to take advantage of employer matching, and put the rest of your retirement savings into a Roth IRA.

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