Should I Have Both a Roth IRA and a 401(k)?
Depending on your income and savings goals, having both a Roth IRA and 401(k) might make a lot of sense. Begin by taking advantage of any available employer match in a 401(k), then use an IRA along with the 401(k) to reach your annual savings target.
There are literally scores of retirement plan options, each offering various tax and investing benefits to savers.
In all seriousness, if we’re just talking about account types (like 401(k)s, IRAs, 457s, etc.) I can think of more than a dozen off the top of my head.
And that doesn’t include defined benefit plans or other savings vehicles like employee stock purchase plans, options, or deferred compensation (which I suppose you could argue is income and not a retirement plan, but I could also argue the counterpoint).
Then, of course, there’s the 25-year-old debate of the merits of Roth versus Traditional versions of the aforementioned account types.
The good news is all this variety does provide one with a high degree of flexibility when selecting a retirement saving path.
The bad news is too many choices make finding the optimal path quite difficult, or worse, could cause one to make no choice at all which is rarely the best choice.
“Choice Overload” is the scientific name for this phenomenon, but I’ve always called it “analysis paralysis.”
Though we won’t unpack the nuances of each retirement account type in this post, you may find our article about prioritizing these options helpful.
Furthermore, even if you don’t need help identifying the best account option for you, you might wonder, “Should I focus completely on one account type at a time or use a more balanced approach?”
With close to 70% of private sector workers enjoying access to some sort of employer-sponsored retirement plan (90% for those who work in government), and anyone with earned income having access to an IRA, it is very common for people to ask the subject question of this post:
“Should I have both a Roth IRA and a 401(k)?”
As usual, the answer is “It depends”.
Let’s dig into why…
How good is your 401(k)?
To begin, you can’t just assume that you should focus completely on your 401(k) for retirement saving because it might be an awful plan.
Most 401(k) plans are great and over 80% offer some sort of matching component for employee contributions.
If that’s the case where you work, then you should almost certainly contribute to your 401(k) plan up to the amount that maximizes your employer match.
The employer match is quite literally free money.
If you’d lean over to pick up a $20 bill, then you should also put forth enough effort to take advantage of this retirement tailwind.
Even if your employer doesn’t provide a dollar-for-dollar match, you should take whatever they give you. It’s still free money.
However, not all 401(k) plans are built equally.
Unfortunately, whether due to the employer not caring or not having the resources, many plans stink.
How so you ask?
Well, these “lesser than” plans commonly offer a small portfolio of high-cost investments and no employer match.
Furthermore, they may have extended vesting schedules meaning any contributions that your employer does make could be taken back if you or they terminate your employment.
If you strip away an employer match and limit investment options, I would argue that the 401(k) is actually less useful than an IRA.
At least in the IRA, you can still choose low-cost securities. Virtually any publicly traded security is available in an IRA.
In summary, if you have a good 401(k) with an employer match, contribute up to the maximum amount your employer will match. If you have a poor plan, you might as well go on to the Roth IRA.
How much can you save?
So, now maybe you’ve decided where to start saving.
The next question is what to do when you run out of room to save in your primary option?
For example, even if you are contributing to your 401(k) up to your employer match, odds are that amount will fall short of the 15%-25% savings rate we suggest in the Next Dollar Roadmap.
On average, a 401(k) plan will match up to 4% of an employee’s contribution. Even if you count the employer portion toward an annual goal that would only total 8%.
If you contribute to the Roth IRA first, you’ll only be allowed to deposit $6,500 ($7,500 if 50 or older) in the account which is 15% of a $43,333 annual income. If you make more than that, you still have some work to do before you hit that mark.
This is where I’d answer our initial question, “Should I have both a Roth IRA and a 401(k)?”, with an emphatic yes.
In these cases, you’ll need both just to optimize your path to achieving a savings rate that will support your future retirement.
However, there are some cases where one will do. If you don’t have access to a 401(k) and your income is such that you can meet your annual savings goal with an IRA alone, then that will suffice.
You may also make too much to contribute directly to a Roth IRA and prefer to keep things simple and just use your 401(k).
Neither of these paths is wrong, but there are other unique characteristics that we’ll cover now to be sure you’re accounting for everything as you make your selections.
Account Types & Tax Treatment
Before we go on, I want to quickly make some clarifying points about our topic.
Anytime one considers the differences between Roth and Traditional accounts, some distinctions should be made.
First, 401(k)s and IRAs are types of retirement accounts. The IRS has rules for how these accounts are utilized, including contribution limits, income restrictions, qualified withdrawals, and so on.
Traditional/Pre-tax and Roth/After-tax refer to the tax treatment of these accounts. Traditional being taxed upon withdrawal and Roth being taxed upon contribution.
The only reason I’m taking a minute to point this out is because it is sometimes assumed that you can only have one or the other.
The truth is most tax-favored retirement accounts are available as Traditional or Roth, meaning you can align whatever account type you have available to you with the tax treatment you prefer.
With this clarification made, let’s look at some pros and cons of each.
Pros and Cons of Roth and Traditional Accounts
Roth Pros
- All withdrawals are completely tax-free
- Contributions (not earnings) can be withdrawn at any time, tax and penalty-free
- No required minimum distributions (RMDs)
- Tax diversification in retirement
- Can be used for other expenses like a first home or education
Roth Cons
- No tax deduction for contributions
- Earnings cannot be withdrawn without penalty until age 59.5
Traditional Pros
- Tax-free contributions and tax-deferred growth
- Tax diversification in retirement
Traditional Cons
- All withdrawals are taxable and cannot begin until age 59.5
- Required minimum distributions (RMDs)
Pros and Cons of IRAs and 401(k)s
IRA Pros
- Account owner can select custodian and choose from a broad selection of investment options
- Preferential tax treatment over traditional investment accounts
IRA Cons
- Contribution limits ($6,500 in 2023)
- Income restrictions may limit high earners from making direct or pre-tax contributions
- Cannot begin withdrawals until age 59.5
401(k) Pros
- Possible employer match
- Preferential tax treatment
- Higher degree of legal protection in most states
- No income limitations for safe harbor plans
- High contribution limits
401(k) Cons
- Limited investment options
- Cannot begin withdrawals until age 59.5 (unless you use the rule of 55)
The Benefits of Account Diversification
There is one other thing to keep in mind as you decide whether or not to use both a Roth IRA and 401(k).
As you begin making withdrawals in retirement, you will likely enjoy the flexibility of being able to make withdrawals from multiple accounts with a variety of tax treatment.
Having this flexibility will effectively allow you to control your income tax obligations in retirement which is a very powerful tool.
Obviously, tax-free money saved in a Roth account will be most valuable, but there are also circumstances where having a bucket of funds that haven’t been taxed may be useful. (Specifically, I am thinking about giving to charity or providing heirs with a free step-up in basis through a standard brokerage account, but there are others.)
Keep an open mind about this over time as your account balances grow.
Prioritizing Your Choices
To summarize, the optimal decision depends on your circumstances.
If you have a good 401(k) plan with an employer-matching contribution of any type, you should maximize that first.
Once you’ve exhausted your employer’s generosity, move to an IRA next (Roth or Traditional) before going back to the 401(k) to finish reaching your savings goal for the year.
Most people will have both an IRA and a 401(k) at some point and there certainly aren’t any drawbacks to having both if you can use them.
