Traditional 401(k) vs. Roth IRA — What Makes the Most Sense for You

At the Financial Gym, we’re all about getting your assets into shape. That means thinking long-term, too, and preparing for retirement. There are various retirement vehicles to choose from which can be good but also overwhelming. 

Photo by @getcroissant

Photo by @getcroissant

Which one is the “right” one for you? It depends, but we’re going to review two of the most common retirement vehicles, the 401(k) and Roth IRA and help you decide which one makes the most sense for you.

The 401(k)

First, let’s review the 401(k). A 401(k) is an employer-sponsored retirement plan that is only offered through your employer. So when you get a full-time job, having access to a 401(k) may be one of the benefits. 

As part of the plan, employees contribute a portion of their paycheck to contribute to their 401(k) retirement plan. If you’re lucky, your employer will match a certain percentage of your contributions, for example, three to six percent. 

Currently, the maximum you can contribute to your 401(k) each year is $19,000. When it comes to taxes, your 401(k) contributions are not taxed, only your withdrawals at retirement age. You’ll be taxed at the income rate you have when you retire.

If you think you’ll have a much higher income with a higher tax rate, you might want to start thinking about how it will affect your taxes and create a strategy. 

The Roth IRA

The Roth IRA is a specific type of Individual Retirement Account. Instead of coming from an employer, any individual who meets the eligibility requirements can open up a Roth IRA. The main eligibility requirement for a Roth IRA is income. 

In order to qualify to open a Roth IRA, your income must be $137,000 or less as an individual. There is a phase-out of contributions though from those earning between $122,000 to $137,000, where you can contribute a reduced amount. 

If you earn less than $122,000 you can contribute the full amount, which currently is $6,000 for those under 50. If you’re over 50, you can contribute up to $1,000 more. 

The Roth IRA differs from the 401(k) in that the Roth uses after-tax income. That means that when you withdraw from your Roth IRA in retirement, no income taxes are taken out. Any gains that you earn are untaxed as well. 

Retirement showdown: 401(k) vs. Roth IRA

Saving for retirement is something everyone should do but not all retirement vehicles are alike. 

Pros of 401(k):

  • May be eligible for employer match

  • Can contribute more money than Roth IRA

  • Not taxed now 

Cons of 401(k):

  • Less control as it’s from employer

  • Will be taxed in retirement years

  • Not as beneficial without employer match 

Pros of Roth IRA: 

  • Limited barriers to entry

  • More flexibility with what investment firm to work with

  • Save money on taxes later

Cons of Roth IRA:

  • Not everyone is eligible based on income

  • There’s an income phase-out

  • Lower contribution limit

After reviewing these pros and cons, you can consider which retirement vehicle might be best for your situation. But here’s something you should know first. 

You can technically contribute to both, if you meet the eligibility requirements for the Roth. Having both options in your portfolio can boost your earning potential and change up your tax situation in different ways. 

But if you feel you only have funds for one retirement vehicle, then choose wisely. If you have a match on your 401(k) from your employer, certainly start there. That’s “free money” even though that’s part of your benefits package and overall compensation. If you earn more money now and want to deduct your contributions to your 401(k), that can help you save money on taxes now. 

If you think you’ll earn more in retirement, then a Roth IRA can be an attractive option as your withdrawals won’t be taxed. Just be aware of the income restrictions, phase out and the contribution limits which are much lower than a 401(k). 

Need any additional support? Schedule a FREE 20 minute warm-up call to learn how your new Best. Financial. Friend can help you figure out which works best for you!