401(k) vs. Roth IRA: What is the Difference?

In a perfect scenario, you might have a 401(k) and a Roth IRA to put aside funds for retirement, but if you have to decide between the two, here are some ways these accounts differ.

401(k) accounts and Roth IRAs are popular tax-advantaged retirement savings vehicles that differ in tax treatment, investment options, and possible employer contributions. It is possible to contribute to both plans, however, contributions to both accounts have to come from wages and other earned income, not investment or rental income.

Named after section 401(k) of the Internal Revenue Code, this retirement saving vehicle is an employer-sponsored deferred-income plan. To contribute to a 401(k), the employee designates a portion of each paycheck to be diverted into the plan. These contributions occur before income taxes are deducted from the paycheck.

The investment options among different 401(k) plans can vary tremendously, depending on the plan provider, but no matter which fund (or funds) the employee chooses for his money, any investment gains realized within the plan are not taxed by the IRS. Taxation only occurs after the employee has reached retirement age and begins to make withdrawals from the plan. These distributions, as they are known, are subject to income taxes at the retiree's current tax rate. If you think your income will be higher when you retire, you may want to plan ahead, as all income from your distributions will be taxed.

As of 2019, the limit for annual 401(k) contributions for those under the age of 50 is $19,000, and those 50 and older can contribute an additional $6,000 per year in catch-up contributions.

401(k) plans are most beneficial when an employer offers a match, contributing additional money to the employee's 401(k) account, usually a percentage of the employee's contribution. This is a form of additional deferred income; it does not directly affect the employee's contribution. In 2019, the maximum annual contribution is $56,000, or $62,000 for those employees ages 50 or older.

A variation of traditional individual retirement accounts (IRAs), a Roth IRA is set up directly between an individual and an investment firm; the individual's employer is not involved.

Since the account is set up and controlled by the account owner, investment choices are not limited to what is made available by a plan provider. This gives IRA accounts a greater degree of investment freedom than employees have with 401(k) plans, though the fees charged by those providers are typically higher. There are quite a few brokers who provide individual retirement accounts.

In contrast to the 401(k), after-tax money is used to fund a Roth IRA. As a result, no income taxes are levied on withdrawals during retirement. While in the account, any investment gains are untaxed.

The contribution limits are much smaller with Roth IRA accounts. In 2019, the maximum annual contribution for those under the age of 50 is $6,000, up from $5,500 in 2018. Those ages 50 and up can contribute an additional $1,000 for a total of $7,000/$6,500 per year.

Individuals who earn more than $137,000 per year in 2019 (up from $135,000 in 2018)—or $203,000/$199,000 for those married filing jointly—are ineligible to contribute. Below those limits, there is a phase-out income group for whom partial contributions are possible. The range for 2019 is $122,000 to $137,000 for individuals and $193,000 to $203,000 for those married filing jointly.

Obviously, it is better to pay taxes on a smaller percentage of your income prior to contributing (as in a Roth IRA) than to pay a larger percentage of taxes on withdrawals (as in a 401(k) or traditional IRA).

A Roth IRA has a five-year rule when it comes to withdrawing your earnings. While you can withdraw your contributions at any time or any age, the five-year rule states that you cannot withdraw your earnings for five years from the first tax year of your original contribution to the account. When you turn age 59½ you can access both your earnings and contributions without penalty or paying taxes.