Few employers offer pensions for retired workers. Social Security benefits can help cover the bare necessities but the average $1,400 monthly benefit doesn’t allow for a comfortable lifestyle as a retiree.
Therefore, it’s up to you to set aside a portion of each paycheck for retirement.
Most people have access to both a Roth IRA and a 401(k) and each has its own benefits and drawbacks. With your 401(k) you will be able to deduct your contributions on your taxes this year and likely also get an employer match, but your withdrawals are taxed in retirement. Meanwhile, contributions to Roth IRA don’t reduce your tax bill but they grow tax-free and provide tax-free withdrawals in retirement.
Popular advice, and the advice I personally agree with, is to contribute to your 401(k) to get the employer match and then max out your Roth IRA. If you still have money to contribute to retirement accounts go back to funding your 401(k).
Table of Contents
- Roth IRA
- Can You Have a Roth IRA and a 401(k) at the Same Time?
- Should You Max Out a 401(k) Before a Roth IRA?
- Is It Better to Invest in a Roth IRA or a 401(k)?
Each Roth contribution uses after-tax dollars. You pay income taxes on your contributions for the current tax year, but you can make tax-free withdrawals after turning age 59 ½ years old. So you can’t reduce your taxable income but all the growth on the account is tax-free.
Also, Roth IRAs do not have required minimum distributions (RMDs) like traditional IRAs. RMDs can force you to withdraw more cash than you need in retirement to avoid a hefty IRS tax penalty.
As a side note for those near retirement, to get the tax break on the growth in your Roth IRA the account must be open for five years. your Roth IRA must be open for at least five years. If you open an IRA at age 60, you must wait until you turn 65 to access the growth tax-free – but you can take your contributions at any time with no tax consequences.
Roth IRA Annual Contribution Limits
You can contribute up to $7,000 between all of your Roth IRAs and Traditional IRAs, in 2024. Investors age 50 or older can make an additional $1,000 catch up contribution raising their annual limit to $8,000 per year.
High-income families may not be able to contribute the full amount to their Roth IRA directly. You run into this situation when your adjusted gross income is above $161,000 for single filers and $240,000 for married households (in 2024). However, there’s always the Backdoor Roth IRA option.
The annual contribution deadline for traditional and Roth IRAs is more flexible than 401(k) counterparts. You have until the federal income tax deadline to make IRA contributions. So, you have until April 15, 2024 to make IRA contributions for the 2023 calendar year. All 401(k) contributions must occur by December 31, 2023 to count as a 2023 contribution.
2024 Limits & Phaseouts for IRAs
For 2024, the IRS has announced that there have been increases to some of the figures.
For the Roth IRA, the contribution limit increases to $7,000 and the phase out ranges have been increased. For single filers and Head of Household goes from $153,000 to $161,000 while the phase out for married couples filing jointly goes from $228,000 to $239,000.
Roth IRA Investment Options
Most Roth IRAs offer multiple investment options:
- Individual stocks
- Index ETF and mutual funds
- Target retirement funds
- Sector ETFs
- Precious metal and commodity ETFs
- Mutual funds (I suggest screening potential funds using Morningstar star ratings)
Full-service brokerages like Vanguard or Fidelity (for example, here’s a comparison of their S&P 500 funds – FXIAX vs. VOO) let you find cost-efficient investment options and $0 trade commission.
A robo-advisor can be a better option if you don’t have the time or skill to manage your portfolio. Here are the best robo-advisors.
Many Roth IRA providers do not charge platform fees. Nor do you pay trade commission to buy individual stocks or ETFs. Most robo-advisors charge an annual management fee of around 0.25% of your portfolio balance. In general, Roth IRAs have lower fees than 401(k) plans.
Most 401(k) plans have a “traditional” tax treatment. Like a Traditional IRA, 401(k) contributions are tax-deferred. You deduct the contribution amount from your taxable income to reduce your adjusted gross income. But you pay income taxes on the withdrawal amount in the future. (here are all the ways to withdraw money from a 401(k))
More employers are also offering Roth 401(k) plans. You pay income tax upfront on your contributions but can make tax-free withdrawals – just like the Roth IRA.
401(k) Matching Contributions
Your employer might match a portion of your annual 401(k) contributions. For instance, they may contribute up to 6% of your annual income.
Employer 401(k) matches are tax-deferred, just like your contributions. So the contribution will not count as income on your tax return but you will pay taxes when you withdraw the money from the account.
If you have a Roth 401(k) your contribution is taxed as income and deposited into your Roth 401(k), but the employer match goes into a traditional 401(k). You must pay income taxes on the employer match once you make a withdrawal.
401(k) Contribution Limits
The annual 401(k) contribution limits in 2024 are:
- $23,000 if under age 50
- $30,500 if age 50 or older
The employer matches do not count against your annual contribution limit.
You have until December 31st to contribute to your 401(k). The clock resets on January 1st, but you can still make IRA contributions until the federal tax deadline for the previous tax year for a potential last-minute tax deduction.
The investment options for most 401(k) plans are typically slimmer than your Roth IRA. Some 401(k) plans are notorious for only offering funds with high expense ratios or poor performance records.
However, the best 401(k) plans let you invest in these products:
- Stock and bond index funds
- Target retirement funds
- Company stock
Your plan may offer additional funds with an active management strategy. Several 401(k) providers offer “robo” fully-automated portfolio.
Your 401(k) plan fees can vary widely which is one reason why 401(k)s are not always the best way to invest for retirement. High fees mean you have less cash to invest and earn compound interest.
A recent Morningstar Investment Management study finds the average 401(k) plan fee is from 0.37% to 1.42% of your account balance. Larger companies tend to have the cheapest fees as they have more pricing power.
Most Roth IRA providers charge no annual account fees or trade commissions. Most robo-advisors charge a 0.25% annual management fee – if you choose the fully-automated route.
Can You Have a Roth IRA and a 401(k) at the Same Time?
Yes, it’s possible to have both a 401(k) and a Roth IRA at the same time and contribute fully to each. If your employer doesn’t offer a 401(k) and you have side hustle income then you have the option to open a Solo 401(k) for your own business.
Should You Max Out a 401(k) Before a Roth IRA?
It’s tempting to max out your 401(k) first each year for three principal reasons:
- You can earn the full employer 401(k) match
- Your employer automatically withholds a portion of each paycheck
- Higher annual contribution limit than a Roth IRA
However, you should compare your 401(k) fees to similar Roth IRA options and also decide which plan has better investment options.
A popular retirement savings strategy is the three-step method:
- Contribute enough to your 401(k) to get the full company match
- Max out your Roth IRA
- Resume contributing to your 401(k) up to the max contribution
You first earn the full employer match to grab that instant and guaranteed 100% return on your investment, then shift your contributions to a Roth IRA. The reason for this is that the Roth IRA will typically have lower fees, more investment options, and will give you tax-free money in retirement.
After reaching your IRA contribution limit, you invest your remaining cash into a 401(k) for the tax break.
Is It Better to Invest in a Roth IRA or a 401(k)?
As you can see, the Roth IRA vs 401(k) debate isn’t always so simple to pick a winner.
Both a Roth IRA and 401(k) make it easy to save for retirement in a tax-efficient manner. Any money you don’t need until retirement should go into a tax-advantaged account. Tax-efficient investing is a gift as many of us look for ways to reduce our annual taxable income.
The better option for you can come down to three main factors:
- Potential fees (i.e., account management fees, trade commissions, fund expenses)
- Investment options
- Tax-deferred (traditional) or after-tax (Roth) contributions
The decision can be easy to make if you have a lousy 401(k) plan. If this is the case, only invest enough to capture the matching contributions and invest the rest into a Roth IRA.
When is a Roth IRA Better?
Roth IRAs can be the better option for most people as you’re less likely to pay expensive account fees or fund fees. Most brokers don’t charge annual account fees or trade commissions.
An increasing number of brokers have a $0 minimum initial deposit so you can effortlessly open a Roth IRA.
Choose a Roth IRA for these reasons:
- Flexible investment options
- Can hold individual stocks and funds in the same account
- No annual account fees
- You want tax-free distributions in retirement
- Your employer doesn’t offer a Roth 401(k) for tax-free distributions in retirement
- No required minimum distributions in retirement
- Can make contributions until the federal income tax deadline (April 15th in most years)
You may also appreciate that Roth IRAs are separate from your current employer. Few of us work for the same employer for our entire working career. You can invest in the same Roth IRA no matter how often you switch jobs.
You will need to perform a 401(k) rollover if you switch employers to access your funds and minimize your plan fees. Even if you quit your job, the 401(k) provider continues charging the annual plan fees. Rolling your old 401(k)s into an IRA merges your accounts into one place.
When is a 401(k) better?
A 401(k) can be superior to the Roth IRA for these reasons:
- Employer matching contributions
- Invest directly from each paycheck
- Traditional 401(k) contribution reduce your taxable income
- Your 401(k) plan has highly-rated investment options
- Higher annual contribution limits ($23,000 vs $7,000 for most people in 2024)
Your 401(k) can be more convenient to invest on a recurring basis. You can tell your employer how much money to withhold from each paycheck to invest. With an IRA, you must take the extra step of scheduling automatic contributions so you never forget to invest monthly.
However, convenience can come at a price. You must decide if the 401(k) fees and narrow investment options are worth it.
The higher annual contribution limits also mean you’re less likely to make excess contributions. You will pay penalties on the excess contributions if you don’t catch them in time.
Both a Roth IRA and 401(k) can help you save for retirement and minimize your annual tax bill. Roth IRAs give you more flexibility with investment options but your yearly contribution limit is small. A 401(k) with an employer match is like free money and can make it easier to invest as you can invest directly from each paycheck.