Roth IRA vs. 401(k): What’s the Difference?

It’s more than just when you pay the taxes

Two people looking at a laptop and paperwork while sitting on a bed at home
•••

 Jessie Casson / Getty Images

A Roth IRA and a 401(k) plan are two common types of retirement accounts. While a Roth IRA is an account you open and manage on your own through the brokerage of your choice, a 401(k) is an account you open through your employer. Both types of retirement plans offer important tax advantages when you invest.

How do you know if a Roth IRA or a 401(k) is right for you? Find out more about the basic differences between the two accounts, and whether you should save for retirement in a Roth IRA, a 401(k), or a combination of the two.

What’s the Difference Between a Roth IRA and a 401(k)?

Both Roth IRAs and 401(k)s are popular forms of retirement accounts. Each account offers generous tax advantages, making them valuable tools for building wealth over time. A Roth IRA is an account you open as an individual, but to invest in a 401(k) plan, you’ll need to work for a company that offers one.

Roth IRA vs. 401(k) at a Glance

  Roth IRA 401(k)
Eligibility Earned income needed. Income can’t exceed a certain yearly threshold.  Can only participate if your employer offers one. No income limits.
Plan Limits 2022: Maximum contribution $6,000, if younger than 50. People 50 and older are allowed an extra $1,000 catch-up contribution.  2022: Contribution limit is $20,500 for people under 50. Those 50 and older can put in $6,500 more for catch-up contribution, if allowed.
Investment Options Individual stocks and bonds, mutual funds, and ETFs. Employer is responsible for choosing the investments. Mutual funds are the most common.
Withdrawal Rules Can withdraw contributions at any time without paying taxes or penalties, unless under age 59 ½. Taxes and 10% penalty due for withdrawing money before age 59 ½, or age 55 if you’ve left your job. Some withdrawal exceptions exist that avoid 10% penalty. 

A Roth IRA is a type of individual retirement arrangement, though it’s more commonly referred to as an individual retirement account. You choose a brokerage, fund the account, and decide what you want to invest the money in. You don’t get a tax break when you fund a Roth IRA. However, your withdrawals are tax-free when you reach age 59 ½, though you can access your contributions at any time without paying taxes or a penalty.

A 401(k) is an employer-sponsored retirement plan that allows you to defer a portion of your salary, which lowers your taxable income. However, more than 86% of plans now allow employees to also make post-tax Roth contributions, according to the Plan Sponsor Council of America’s 64th Annual Survey of 401(k) and Profit Sharing Plans. Some plans match a portion of employee contributions, providing extra incentive to invest.

You can contribute to both a Roth IRA and a traditional IRA in a tax year. However, your contributions between the two accounts can’t exceed the IRA contribution limit for the year. 

In 2021 and 2022, the contribution limit is $6,000 if you’re under 50, or $7,000 if you’re 50 or older.

Eligibility

Roth IRA eligibility: To fund a Roth IRA, you need earned income. Earned income is essentially money you earn from working, such as a salary, wages, tips, bonuses, and self-employment income. Your income also can’t exceed a certain threshold for the year. In 2022, the Roth IRA income limits are $144,000 if you’re single, head of your household, or married filing separately, and $214,000 if you’re married filing a joint tax return.

401(k) eligibility: You can only participate in a 401(k) if your employer offers a plan. There are no income limits for participating in a 401(k) plan. If your employer offers a 401(k), they must allow you to participate as long as you’re at least 21 and have one year of service.

Plan Limits

Roth IRA limits: In 2022, you can contribute up to $6,000 to a Roth IRA if you’re younger than 50. People 50 and older are allowed an extra $1,000 catch-up contribution. These amounts are unchanged from 2021. Contributions are limited to your taxable income for the year, so if you only made $3,000 in 2021, your maximum contribution would be $3,000.

401(k) limits: The 401(k) contribution limit in 2022 is $20,500 for people under 50, up from $19,500 in 2021. Workers 50 and older can make an additional $6,500 catch-up contribution if the plan allows it. Total employee and employer contributions can’t exceed $61,000 in 2022 or the employee’s compensation for the year. However, the $6,500 catch-up contribution doesn’t count toward the limit.

Investment Options

Roth IRA investment options: You can open a Roth IRA through whatever brokerage you choose and select your investments. You can invest in individual stocks and bonds, mutual funds, and exchange-traded funds (ETFs).

401(k) investment options: Your employer sponsors your 401(k) plan and is responsible for choosing the investments. Mutual funds are the most common type of 401(k) investment. The average plan offers eight to 12 investment options.

Withdrawal Rules

Roth IRA withdrawal rules: You can withdraw your Roth IRA contributions at any time without paying taxes or penalties. But if you withdraw your earnings before age 59 ½, taxes and a 10% penalty will typically apply. If you tap into your earnings after age 59 ½ but you haven’t met the Roth IRA five-year rule, you’ll owe income taxes but avoid the 10% penalty. Roth IRAs don’t have required minimum distributions (RMDs), which means you aren’t required to take money out during your lifetime.

You can avoid Roth IRA early-withdrawal penalties in some circumstances, such as if you become disabled or you’re using the money for a first-time home purchase, college, birth, or adoption.

401(k) withdrawal rules: You’ll typically pay taxes and a 10% penalty if you withdraw your 401(k) money before age 59 ½, or age 55 if you’ve left your job. In some situations, such as if you become disabled or need the money for medical expenses above a certain threshold, you can avoid the 10% penalty. Unlike Roth IRAs, 401(k)s come with mandatory RMDs. You must start withdrawing your money by age 72, even if you’re not retired.

Which Is Right for You?

A Roth IRA is a great way to save for retirement if you don’t work for a company that offers a 401(k). But if your employer offers a 401(k) and matches part of your contributions, try to contribute enough to get the full match. Otherwise, you’re passing up free money.

Fortunately, you don’t have to pick between a Roth IRA vs. a 401(k). As long as your income falls within the Roth IRA income limits, you can fund both accounts.

Once you’ve gotten your full employer 401(k) match, it often makes sense to focus next on maxing out your Roth IRA because with it, you have more investment options and the ability to access your contributions whenever you want. If you have extra money to invest beyond that, you can increase your 401(k) contributions.

The Bottom Line

In summary, a Roth IRA is a retirement account you open as an individual through a brokerage firm, while a 401(k) is an employer-sponsored retirement plan. Roth IRAs are always funded with post-tax money. A traditional 401(k) is funded with pretax dollars, but many plans now also offer a Roth 401(k) option that lets employees contribute on a post-tax basis to get a tax break in retirement.

Early withdrawal penalties often apply if you withdraw money from a Roth IRA or 401(k) before age 59 ½, though with a Roth IRA, the penalties only apply if you’re withdrawing your earnings.

Article Sources