Which is better a 401(k) or Roth IRA?
Generally speaking, the lower your income tax bracket is, the more likely you are to benefit from Roth-type savings vehicles. On the other hand, if you have a high income, you will likely benefit from using a Traditional 401(k) or IRA instead of the Roth versions of these accounts.
This post is part of our “People Also Ask” series where we’re plucking questions straight off the world’s most popular search engine and answering them directly.
Asking if a 401(k) or Roth IRA is better is sort of like asking if ice cream is better than hot chocolate.
They’re both delicious and very edible, but their appeal is highly dependent on a variety of circumstances. Like how most people don’t want ice cream while playing in the snow, nor do they seek hot chocolate at a 4th of July picnic.
Ultimately, the decision depends on what else is going on in your financial life. To understand why, let’s start by talking about what these two retirement plans are.
What is a Roth IRA?
A Roth IRA is a type of IRA (or Individual Retirement Account, not to be confused with an Individual Retirement Arrangement of which a standard IRA is one*), the other popular type being a traditional IRA.
You can read about the differences between Roth vs Traditional IRAs and 401(k)s in this previous post.
To summarize, a Traditional IRA allows savers to take an income tax deduction for contributions to the account.
A Roth IRA does not allow account owners to take a deduction for their contributions, but all qualified withdrawals can be made completely tax-free.
There are actually six different types of IRAs, but Roth and Traditional are by far the most common.
*Don’t look at me. The IRS coined all these stupidly similar names. I’m just the messenger.
What is a 401(k)?
A 401(k) plan is an employer-sponsored retirement plan one obtains access to through their work.
The real beauty of 401(k) plans is the opportunity for an employer to make contributions on behalf of their employees.
This is commonly referred to as the employer match and it is an exceptionally valuable financial planning tool.
In fact, when prioritizing your own financial plan, we recommend you take advantage of your employer match even before paying off debt or building out a fully funded emergency fund.
There are nine stops on our Next Dollar Roadmap and employer match is stop #2, right after having an uh-oh fund for basic emergencies.
You cannot afford to pass up that free money, but we’ll get back to that in a minute.
How these two Accounts Are Similar
Both 401(k) plans and Roth IRAs receive tax-advantaged treatment from Uncle Sam to encourage retirement saving.
Frankly, the tax sheltering provided by these accounts can make a huge difference in your long-term net worth.
Both 401(k)s and IRAs can be funded with Roth (After-tax) and Traditional (Tax-Deferred) dollars.
The tax treatment for contributions and withdrawals is the same for these accounts and only varies based on which tax treatment type (Roth or Traditional) you choose.
You also have to be 59.5 years old to begin making penalty-free withdrawals from both of these accounts, though there are some exceptions to this rule too.
The rollover and conversion treatment for 401(k)s and IRAs is similar too, but you cannot roll a Roth account into a Traditional account though the reverse is allowed.
We’re about to point out several things that make these accounts different, but before we do, please don’t forget that ultimately they both operate in a very similar fashion.
We’ll get to which one you should prefer in a bit.
How These Accounts Are Different
Now that we’ve acknowledged the basic similarities of these accounts, let’s highlight their differences.
To begin, you generally can’t get an employer match in an IRA (SIMPLE IRAs are an exception).
This feature easily makes 401(k)s a more potent wealth-building tool if your plan offers a match. Not all of them do.
401(k)s also allow for much larger contributions. In 2023, the standard maximum tax-advantaged contribution limit to a 401(k) is $22,500 while IRAs are capped at $6,500.
IRAs also have income restrictions meaning those of you with higher incomes may not be able to contribute, though there is a backdoor.
401(k) plans do not have any income restrictions unless you are a highly compensated employee in a plan that is not considered a safe harbor plan.
Roth plans (both in a 401(k) and in an IRA) allow the contributions to be withdrawn tax-free and penalty-free since the contributions were taxed going into the account. Earnings would be taxed and penalized in the event of an early withdrawal.
Unqualified withdrawals from Traditional accounts are subject to applicable income tax and a 10% early withdrawal penalty.
Finally, the investment options in a 401(k) account are typically more limited than in an IRA.
This is because 401(k) plans are managed by companies that have an interest in encouraging plan participants to use their branded investments and funds.
Typically, the entire market of securities is available from an IRA. So, they are generally thought to provide more flexibility for aligning one’s investment choices with their goals.
So, Which One Is Better?
Now that you have a little information about how each of these accounts work, hopefully, the answer to the primary question “Which is better?” is becoming more evident to you.
Furthermore, I hope you can understand why we said it depends on your personal situation.
Based on the way the question is phrased, I will assume the inquirer was seeking to discern the better option between a Traditional 401(k) and a Roth IRA even though it isn’t clearly specified.
We wrote a post that walks through how to prioritize investment options, but we’ll unpack some of that here to compare 401(k)s and IRAs specifically.
Generally speaking, if your income places you in a lower tax bracket (12% or lower) a Roth IRA will probably serve you better because you’re unlikely to have a lower tax rate when you make withdrawals in retirement.
Conversely, if you have a high income (32% and up bracket) you will likely benefit from the tax-deferred benefits of a Traditional 401(k) plan over the Roth IRA because you are more likely to be withdrawing in a lower tax bracket when you retire.
If you’re in the middle tax brackets (22% and 24%), it is a little more difficult to decide.
- High income tax states will make the Traditional plan more valuable;
- The younger you are, the more valuable the Roth will be;
- If you think taxes will go up in the future, you may want to favor Roth;
- If you think taxes will go down in the future, you may favor Traditional;
- You can always hedge and balance your contributions to both.
You should also remember that your deductions for Traditional plans and contributions for Roth plans are made based on your marginal income tax rate.
Withdrawals in retirement could be made beginning at lower tax brackets. We talk more about the potential impact of the bottom and top of the tax table in our Roth vs Traditional mega post.
Remember too that the Traditional and Roth options are usually available for both 401(k)s and IRAs. As a result, you probably have tax flexibility no matter which tax-advantaged savings account you use (401(k) or IRA).
But Which Account Type Is Better?
What we haven’t addressed up to this point in much detail is which account type is better.
All other things equal, an IRA has a slight advantage over a 401(k) because of the investment flexibility and lower costs available.
However, if your 401(k) comes with an employer match, there’s really no contest. The free money available in the employer match makes the 401(k) far superior for building wealth.
Most of the time it will make sense to follow this path:
- Use your first invested dollars to maximize any available employer match;
- If you still have funds available to invest, maximize a Traditional or Roth IRA (depending on your tax situation);
- If you still have funds available to invest, go back to the 401(k) and invest up to your savings goal or until you max out your contribution amount.
Of course, none of this information factors in access to 403(b) plans, 457s, or HSAs. If you have access to any of these it may alter your decision.
Again, this post about prioritizing available retirement account options may help.
Conclusion
This question has been asked in many different ways.
To arrive at the optimal answer, one needs a basic understanding of how their own tax situation aligns with the retirement account options available to them.
Here are some links to posts that will help you understand this topic further. Some of these have already been linked above.
