Roth IRA vs. 401k: Which is Right For You?

Have you wondered what the difference is between a Roth IRA vs. 401k?

If you have asked this question, don’t worry. You’re not alone. Somehow, our education system teaches us history and science, but forgets to teach the fundamentals of investing and retirement.

Both a Roth IRA and 401k are great ways to help you take advantage of compound growth so you have more money when you get older. While a 401k is quite common for most people, a Roth IRA is more of a mystery to most.

But a Roth IRA is an incredible tool for your future retirement. Not to mention, when paired with a 401k they are an epic one-two punch for building your net worth.

This post will clearly break down how you can use a Roth IRA, a 401k and the magic of compounding to end up wealthy. Because let’s get real, who wants to work in retirement!?

Here’s everything you need to know.

What is a 401k?

A 401k is an employer-sponsored retirement plan and the most frequently used option these days to fund retirement. A 401k is only offered through an employer and not something you can sign up for at any brokerage firm.

Once you enroll in a 401k, you select a percentage of your paycheck to be directly deposited into your 401k account.

You can choose 1% or 100% of your paycheck, as long it stays under the annual minimum of $18,500 ($24,500 if you are 50 or older). Note these figures are for 2018 and may change in future years.

This money is pre-tax, which means contributions have not been taxed yet. They’re directly taken from your paycheck before taxes are applied, lowering your taxable income.

That may allow you to contribute more than if the contributions came from post-tax income.

Once you reach retirement age you can then withdraw from your 401k, but your withdrawals will be taxed. This can be a positive scenario in the future as it is based on the assumption that you will be in a lower tax bracket at retirement age.

The one downside? The maximum amount you can contribute is $19,500 as of 2021 ($26,000 if you are 50 or older). Sorry high-income earners, there are no upper-income brackets at this time.

Employer contribution

One of the biggest perks of a 401k is that your employer can match a portion of your contributions.

I hate to use the term “free money” as it is a perk of your employee compensation package but this is how many people view employer contributions.

Employer contributions can come in the form of a percentage or annual lump sum. For example, my old employer only matched up to $1,000 each calendar year.

Other employers may match 1%–6% of your total contributions. The most common employee match is 50 cents on the dollar for up to 6% of your pay.

That means if you make $100,000 a year and invest $6,000 (6% of $100,000), your employer will throw in $3,000 for the year.

This is a huge benefit for you. And that $3,000 match doesn’t count toward the $19,500 maximum total.

The total amount that can be contributed between you and an employer in 2021 is $58,000. That includes employee contributions, matching contributions, bonuses and other deferred compensation. (The max if you are 50+ is $61,000 in 2018.)

Basics of 401k contributions

• If you’re under age 50, you can contribute up to $19,500 per year.
• Those age 50 and older can contribute even more with a “catch-up” contribution of $6,500.
• 401k’s are offered through your employer only.
• Unlike with a Roth IRA, you can contribute no matter what your annual income is.
• You’ll have limited investment options. The fund provider, i.e. Fidelity or another brokerage, selects what funds you can contribute your money too.

Advantages of a 401k

1. Money is contributed with pre-tax earnings

When you contribute to a 401k you will be investing money before it has been taxed. The money will be taxed when you withdraw it in the future, when your tax bracket will presumably be lower.

2. Employer match

Again, this is known to most people as “free money” toward your future retirement. It’s hard to beat your employer giving you money just for contributing to your own retirement!

3. Direct deposit

No willpower is needed with a 401k. Once you set up your 401k and contribution amount, the percentage will be automatically deducted from your paycheck.

This way you won’t spend all of your paychecks and forget to invest. This is known as paying yourself first.

Quick note: If you’re in a commission or sales role it might be a good idea to change your contribution amount before a big bonus, depending on your goals. With 401k’s you can change your allocation amount online each pay period.

4. No annual income limits

Whether you make $50,000 or $1,000,000 per year, you can still invest in a 401k plan.

5. Higher annual contribution amounts

Compared to a Roth IRA, you can contribute nearly four times the amount each calendar year to a 401k. With compounding, this can make a huge difference. More on the benefits of compounding below.

Disadvantages of a 401k

1. Limited investment choices

With 401k’s, you can only invest your money into accounts within your employer-sponsored 401k plan. You can’t start investing in specific stocks, index funds or other types of vehicles that aren’t included in the plan.

2. Hard to withdraw your money

If you try to withdraw your money before age 59 1/2, expect a 10% fee plus taxes! This is why it’s a great idea to have a Roth IRA and a 401k.

How does a 401k work?

Here’s a real-life example of a 401k in action.

If you invest 15% of your $2,000 bi-weekly paycheck you will contribute $300 a pay period ($2,000 X .15). If you invested 15% after taxes it would be in the $190–$230 range, depending on your tax bracket.

Remember, you will be taxed in the future when you begin to withdraw your 401k. This is usually after you are 59 1/2 years old.

How are 401k’s taxed?

401k contributions are tax deductible so your gross, taxable income will be lower, which can get you into a lower tax bracket now.  

Roth IRA

People generally seem to correlate investing for retirement with an employer-sponsored 401k.

This is definitely the most common option but there is another that has more flexibility and lets you grow your money tax-free over time. This is known as a Roth IRA.

What is a Roth IRA?

A Roth IRA is a retirement account that you set up directly with an investment firm, not with your employer. When starting a Roth IRA you can choose from tons of different online investment firms, such as E-Trade, Fidelity, Vanguard, etc.

After you open the account, you deposit money from your bank account into a Roth IRA. The best part?

Once you withdraw the money after 59½ years old, you get the investment and gains 100% tax-free!

Remember, the money has already been taxed from your regular income so you aren’t taxed again in the future. This is a huge advantage as you get older. It means all of the earnings your money generates over the years won’t ever be taxed.

Plus, a Roth IRA is way more flexible than a 401k. Remember, with a 401k your investments haven’t been taxed.

Therefore, if you want to withdraw the money, not only do you have to pay the roughly 30% tax bill but also a 10% early withdrawal penalty.

Basics of a ROTH IRA

• Money is contributed to your Roth IRA with post-tax earnings. This means the money has already been taxed and won’t be taxed again in the future.
• If you’re under 50 years old, you can contribute up to $6,000 per year.
• If you’re 50 years or older, you can contribute up to $7,000 per year through what is known as a catch-up contribution.
• You can contribute to a Roth IRA until tax day the following year (technically giving you 15.5 months to max out).
• This is an account that you open with a broker and is not offered through an employer.
• There are specific income requirements to be able to invest in a Roth IRA:
  • If you file taxes as a single person, your modified adjusted gross income must be under $125,000 in 2021. You cannot contribute once you make over $140,000.
  • If you file taxes as a married couple, your joint modified adjusted gross income must be less than $198,000 in 2021. You cannot contribute once you make over $208,000.

Advantages of a Roth IRA

1. Choose your own investments

My personal favorite advantage of a Roth IRA is that you can choose your investments!

With a 401k you’re only able to choose from a select group of funds that are assigned by your 401k provider. Unfortunately, a lot of those options are high-cost mutual funds or target date funds.

Target date funds are right for some people, but they tend to have high fees that can eat away your long-term gains. You may also have access within a 401k to a few good low-cost index funds but the selections are usually pretty slim.

With a Roth IRA, you get 100% choice of where to invest your money.

2. Your money grows tax-free

Again, this is a huge advantage of using a Roth IRA and is the opposite of a 401k. You won’t need to worry about what your income tax situation is, as you’ll shield yourself from any future tax changes.

The only time you would pay taxes is if you withdraw your earnings before the age of 59½ years old. This is one of my favorite reasons to choose a Roth in the Roth IRA vs. 401k debate!

3. Diversify your taxes within your retirement accounts

If you just retire with a 401k you’ll be left with money that has yet to be taxed. But if you have a Roth IRA as well, you can collect those earnings tax-free in the future. This adds diversification to your future income.

4. You can pass it along

With a Roth IRA, you are able to pass any unused funds along to someone else, such as a significant other or child.

5. No required minimum distribution

With a 401k, you generally are required to begin making annual withdrawals from your account — and paying taxes on those withdrawals — every year when you reach age 70½. Not so with a Roth. You can choose to withdraw whenever you want.

6. You can withdraw contributions tax-free at any time

Yes, you read that right. With a Roth IRA, you can withdraw your contributions (not earnings) tax-free whenever you like, even before you reach age 59½.

It’s not recommended in most cases, but it’s still a great option in case your emergency fund goes to zero. Keep in mind that your earnings may be subject to taxes and penalties.

Disadvantages of a Roth IRA

1. Income limits

If you make more money than is allowed by the government you can’t invest in a Roth IRA. You can still use a traditional IRA or even a backdoor Roth IRA.

2. Not tax deductible

Unlike 401k’s and traditional IRAs, your contributions to Roth IRAs are not tax deductible. In the end, I still think this is more of an advantage, as you can withdraw the money plus any gains tax-free later on in life.

I wasn’t able to come up with many disadvantages because Roth IRAs are such a great retirement vehicle.

Why don’t more people use Roth IRAs?

But why do so few people have Roth IRAs? In my opinion, people don’t open Roth IRAs for several reasons:

1. Lack of awareness. Why isn’t this taught in school?
2. Manual setup and effort. Unlike a 401k, you need to set this up and contribute on your own, which takes more effort, learning and discipline than a 401k.
3. Some people can’t afford to save any more money or are intimidated by the entire process.

I think the biggest reason is intimidation. I know it was for me. Even though I read several personal finance books that explained all the great advantages, I still didn’t open a Roth IRA until my late twenties.

Looking back, the questions below made me procrastinate when I first wanted to open a Roth IRA. Unfortunately, I procrastinated an extra year after first reading about it and cost me some money.

Top questions about Roth IRAs

Why should I open a Roth IRA?

Tax-free gains, the ability to withdraw your contributions anytime, and choice of investments.

Where do I open a Roth IRA?

Most brokerages let you open them for a minimal fee, including E-Trade, Fidelity, TD Ameritrade and Vanguard. More on these below.

How do I open a Roth IRA?

It’s surprising how easy it is to open a Roth IRA. Simply log onto the site where you want to open your IRA and follow the steps.

How do I contribute money to a Roth IRA?

Once you’ve opened your account you can deposit funds directly from a bank account. You can also set up automatic contributions on a recurring schedule.

What is the contribution limit for a Roth IRA?

As of 2018, the contribution limit is $5,500 if you are under 50 years old. You can add an extra $1,000 if you are 50 or older.

How do I decide what stocks, bonds or funds to pick?

With a Roth IRA, you can make any investment, unlike your 401k, which has limited options that are provided by your employer’s retirement program.

Overwhelmed by choices? Index funds are one way to invest that requires minimal effort on your end and keep costs low.

As Vanguard states, “Instead of hiring fund managers to actively select which stocks or bonds the fund will hold, an index fund buys all (or a representative sample) of the securities in a specific index, like the S&P 500 Index. The goal of an index fund is to track the performance of a specific market benchmark as closely as possible. That’s why you may hear it referred to as a ‘passively managed’ fund.”

Roth IRA compounding example

Here is an example that shows compounding within a Roth IRA.

• A 29-year-old makes a $5,500 initial contribution
• Continues to make $458 monthly contribution ($458 x 12 = $5,500 = maximum annual contribution for Roth IRA)
• Invests for 30 years
• Never withdraws money prior to 59½ years old
• Averages 8% annual return

Total Contribution Amount: $165,000

Total Fund Amount: $728,246.89  

In total, $627,446 was gained from compounding! You only contributed 22% of the entire amount.

Compounding was the reason your investment more than quadrupled in three decades. A Roth IRA has already been taxed, so when you retire you are able to keep all $728,247!

This example was based on an 8% return. Historical market returns are 7%–9%.

Here is the breakdown with 7%, 9% and 10% returns.

• 7% return: $597,769
• 9% return: $890,136
• 10% return: $1,091,161

10% return is over $1,000,000!

Best Roth IRA brokers

As I mentioned, to enroll in a 401k with your employer is simple. But a Roth IRA requires more work on your end and is one of the main reasons I think people don’t take advantage of this retirement vehicle.

In reality, it doesn’t take long to find a provider, set up deductions and start saving for your future. Here are the best IRA providers, in my opinion:

Vanguard

Vanguard is one of the most trusted brokerages in the industry. It prides itself on keeping costs low for investors by focusing heavily on low management costs for exchange-traded funds (ETFs) and other index funds.

When I signed up for a Roth IRA with Vanguard it took me 15 minutes from start to finish.

Benefits of Vanguard

• If you choose Vanguard funds (which typically have the lowest fees in the industry) there are no transaction fees (front-end or back-end loads)! This can save you thousands of dollars in fees in the long run.
• Excellent customer service and support.
• Easy to sign up and tons of low-cost investing options.

E-Trade

E-Trade is another great way to start a Roth IRA. It was one of the first brokerages to go online, and it has a very robust platform. Plus, it has physical offices if you have questions and prefer to speak to someone in person.

The one major downside of this brokerage is the higher cost transaction fees. Trades start at $6.95; $4.95 if you do 30 or more transactions per quarter.

Benefits of E-Trade

• 24/7 customer services and physical branches.
• Low account minimums. Unless you’re trading options the minimum is only $500 per account.
• Access to more than 9,000 mutual funds. More than 4,400 of them have no load and no transaction fees to keep costs low for you.

TD Ameritrade

TD Ameritrade has been around for more than 40 years and has 11 million client accounts. Fees for TD Ameritrade transactions start at $6.99, about the same cost as E-Trade.

The tradeoff is that you get the chance to speak with a financial adviser at no cost or obligation to you. This is a huge perk if you have any questions that you need answered about your long-term financial goals.

Benefits of TD Ameritrade

• No minimum deposit! Seriously, none.
• 24/7 Customer support and local branches.
• Powerful research tools and advanced trading dashboard to help you make the best investing decisions.

Robo Advising Roth IRA Options

If you’re not comfortable making your own investments for your Roth IRA there are plenty of great options with robo-advisors. These programs help you manage your retirement funds without having to worry about researching, choosing, and potentially making the wrong investment choices.

All of these platforms do their best to minimize fees for you and provide solutions to retirement with low-cost, ETFs.

Empower

You might have used Empower to track your budget, measure your net worth, and take advantage of a ton of free tools. Their free service is incredible and highly recommended, as it makes it easy to sync up all your accounts in one place. This will allow you to monitor your spending, saving and returns to reach your long-term financial goals.

But Empower has a paid investment option as well. Its services will give you access to a personal financial adviser and assistance in finding the right low-cost index funds.

Here is the fee structure based on your total portfolio amount:

• Accounts up to $1 million: 0.89%
• Accounts up to $3 million: 0.79%
• The next $2 million: 0.69%
• The next $5 million: 0.59%
• Over $10 million: 0.49%

As you can see, the more you have invested the lower the fees. While they might seem high for investments under a million they are a mere fraction of what a traditional adviser would charge. If you don’t like studying the market and investing on your own this is a great option.

Even if you don’t use them to open a Roth IRA, take advantage of all the free tools. They can help you ensure that you’re not overpaying for fees and have the right asset allocation.

Betterment

Betterment is another robo-adviser that is a great option for your Roth IRA. The folks at Betterment understand the power of fees and how much they can eat away at your investment gains in the long run. To minimize fees, Betterment invests using low-cost ETFs that try to match a specific index.

Betterment has other features to help manage your wealth including:

• Tax-loss harvesting.
• Automated portfolio rebalancing.
• Automatic dividend reinvestment.
• No trade fees, transaction fees, or rebalancing fees.

Plus, the fees are very low! If you use Betterment Digital your fee is .025% of your total portfolio and 0.40% with Betterment Premium (which requires a $100,000 minimum).

WealthFront

The other robo-adviser option is WealthFront, which is very similar to Betterment. They focus on low-cost ETF”s and do not allow individual stock trading.

Wealthfront has several of the same features as Betterment, including tax-loss harvesting, automated portfolio rebalancing, and access to the Wealthfront invite program. This will help you earn free services for referring family and friends to the program.

The best part about WealthFront? The fee structure.

Balances under $10,000 are managed for free and those above $10,000 incur only a .025% management fee annually. This is an amazing way to reduce fees and save more of your money for retirement.

Compounding: the powerful argument for starting early

Compounding is how you are able to retire wealthier than you thought possible. With compounding, your earnings grow earnings, even if your principal doesn’t change. 

Who benefits from compounding?

Everyone! Seriously, whether you are investing $100 or $1 million. Anyone can benefit, no need to be a Wall Street guru.

The longer your money compounds, the more money you will earn. Money that grows at 6% a year would double in 12 years. In four years, it would quadruple.

Compounding example

Here’s an example to show the power of compounding. Assume you had $1,000 and it grew a modest 6% per year.

Initial deposit: $1,000. Annual growth: 6%.

1st year: $1,200
2nd year: $1,1440
3rd year: $1,728
5th year: $2,488
10th year: $6,191
20th year: $38,337
30th year: $237,376

This example assumes that you don’t invest more than $1,000. After 30 years you would have gained $236,376, or a 23,637% increase!

What if you maxed out your retirement accounts?

Compounding with a 401k

What if you maxed out your 401k?

In this example, I’ll use the 2017 maximum allowed contribution and won’t even factor in an employer match, as that will differ for everyone.

• Starting value: $0
• Annual contribution amount: $18,000
• Employer match: $0
• Number of years to retirement: 35
• Average rate of return: 8%

401k contributions: $630,000

Total 401k value: $3,234,529.

Note that your money has not been taxed yet and will be when you begin to withdraw in retirement.

Compounding with a Roth IRA

In this case, your contributions are made with post-tax money. This means you have been taxed already and will not be again in the future.

• Starting value: $0
• Annual contribution: $5,000
• Number of years: 35
• Average rate of return: 8%

Roth IRA contributions: $192,500

Total Roth IRA value: $947,742.

Total retirement savings of 401k and Roth IRA: $4,182,271. This does not even include employer matches, which may make the total much more.

You could retire with more than $4 million. Not bad for just using two traditional retirement accounts.

Roth IRA vs. 401k Recap

If you contribute to both a Roth IRA and a 401k you are taking advantage of the two biggest retirement accounts. These accounts will help your savings grow faster and larger than a non-tax-advantaged brokerage account.

The more you contribute to your retirement savings accounts each year, the more money you will have in retirement.

Since it’s impossible to know what tax bracket you’ll be in at various stages in retirement, it’s great to have both accounts. It’s not a bad idea to have some retirement savings in pre-tax (401k) and post-tax (Roth IRA) accounts.

Then you can strategize your distributions to minimize your tax liability and diversify your retirement holdings.

Don’t let a lack of planning when you’re young ruin your future.

Being a frequent golfer I get to meet a lot of people, especially older people. Anytime I meet someone who is “retirement age” I ask them if they would’ve done anything different in their 20s or 30s.

Nine out of 10 times I hear how they wish they had started saving earlier.

Use a 401k and Roth IRA to start funding your retirement plan, and your future self will thank you. Remember: Act as if retirement is on the horizon.