Understanding the Difference Between a Roth IRA and a 401(k)

Roth IRAs and 401(k)s are among the most common choices for retirement savings. But how do you decide which is best for you? 

Learning the key differences between these two types of accounts will help you determine which option to choose—or if it makes sense to leverage both.

The basics of Roth IRA versus 401(k)

One of the biggest differences is that a 401(k) requires an employer, and a Roth IRA doesn't. A 401(k) is a retirement plan that companies sponsor for their employees, while anyone who meets the income requirements can open a Roth IRA.

Another major difference pertains to investment choices. Roth IRAs generally let you incorporate a broad selection of options, including mutual funds, stocks, bonds, certificates of deposit and exchange-traded funds. Your choices may be more limited in a 401(k).

On the other hand, a 401(k) often comes with the significant advantage of a company match. Many employers match all or part of employee contributions. This free money could help you achieve your retirement goals faster. When you change jobs, you may be able to keep your plan where it is or roll it over to a new employer's plan. You might even be able to roll it into an IRA.

Tax differences

Tax benefits are another point of distinction between a Roth IRA and a 401(k). Both offer significant tax breaks, but they do so in different ways.

Because you make Roth IRA contributions on an after-tax basis, the tax advantage isn't immediate. However, you won't pay taxes on any investment earnings if your distribution is qualified, which means it satisfies certain requirements. The primary rule is that all withdrawals are tax- and penalty-free if you're 59½ or older and your account has been open for 5 years.

In contrast, you'll make pre-tax contributions to your 401(k) through payroll deductions, which reduces your taxable income for each year you contribute. You won't pay taxes on your contributions or earnings until you receive a distribution from the plan. If you withdraw funds from your 401(k) before age 59½, and if you don't qualify for certain exceptions, the taxable portion is usually subject to a 10% penalty.

While you can leave your money in your Roth IRA as long as you wish, you generally need to withdraw a minimum amount from your 401(k) each year to avoid a penalty starting at age 72—or 70½ if you reached that age before Jan. 1, 2020.

Contribution limits

How much you can contribute to a Roth IRA or a 401(k) might be quite different, with the employer-sponsored plan generally allowing you to contribute significantly more.

The IRS sets contribution limits annually for both types of accounts. For the 2020 tax year, employees can contribute up to $19,500 to their 401(k) plans. Workers age 50 and over can also make a catch-up contribution of up to $6,500.

The 2020 limit on contributions to a Roth IRA—actually to all IRAs combined, whether traditional or Roth—is $6,000. For those age 50 or older, it's $7,000.

From there, the rules for Roth IRA contribution limits can get tricky. For example, you aren't able to contribute more than your taxable compensation for the year if it's less than the limits. Some contribution limits go down as incomes rise, and individuals at higher incomes may not be able to participate at all.

Ability to access money early

Although both types of accounts are designed for long-term investing, they each have rules allowing participants to access funds in certain instances without being penalized. You may be able to borrow money from your 401(k), for example, although the rules vary with each plan.

With Roth IRAs, you can withdraw contributions—but not earnings—tax-free and penalty-free any time. However, there are some circumstances that allow you to withdraw earnings without being subject to taxes or the early withdrawal penalty. For example, you can tap up to $10,000 if you put the money toward a first-time home purchase and your Roth IRA has been open at least 5 years.

Better together

Saving in either a Roth IRA or 401(k) can help you build up your nest egg and stay on track for retirement. If you're able to set enough money aside to contribute to both accounts simultaneously, you can diversify your investments and access a mix of tax-free and tax-deferred growth in retirement.

One common strategy is to contribute at least enough into your 401(k) to get the maximum matching contribution from your employer before contributing to a Roth IRA. A financial advisor can help you determine the best way to allocate your funds among these two popular retirement accounts.