Roth IRA vs. 401(K) – What is the Difference?

When it comes to saving for retirement, there are lots of options out there! It can get extremely overwhelming and confusing to know the differences between all the different account options. While there are many more options other than a Roth IRA and a 401(K), these are two of the most popular options. But what are they and what are the differences? This post explains what each account offers, the different advantages and disadvantages to both and the core differences between the two.

A Roth IRA and a 401 (K) are the two of the most popular account options when it comes to saving for retirement. A Roth IRA is an individual retirement account, hence ‘IRA’. A 401(K) is a retirement plan that is offered by an employer. The main differences between the two is how contributions are made to each account and how the contributions or withdrawals are taxed. A Roth IRA is funded with after-tax income, while a 401(K) is often funded with pre-tax income. You can start a Roth IRA at any time in your life. However you cannot start a 401(K) until you start your first full time job or career. It is important to understand the difference between these two account options so you can decide which is better for your future retirement, financial, and taxation goals.

Roth IRA:

Roth IRA’s are funded with after-tax income, this is simply a fancy way of saying that your contributions to the account are taxed as your money is going into the account. This means when you are ready to make withdrawals from the account – they are tax-free. The amount you have in your account is the exact amount of what you are able to withdraw with no tax penalties (if you are of age). You can open a Roth IRA account yourself through some kind of financial institution – either a brokerage / investment firm or bank.

Let’s say you have $250,000 in your Roth IRA account. If you are old enough to make withdrawals without penalties, then you have exactly $250,000 that you can use. This is because your contributions were already taxed when you put the money into your account. This can be extremely advantageous, especially when you are young. As you were likely making these contributions when you were in a lower tax bracket. When it comes to a Roth IRA, time is your best asset, the earlier you open a Roth IRA account – the better.

Another advantage of the Roth IRA is that if you are under 59 ½ years old and have had the account for at least five years, you can make withdrawals on your contributions at any time. It is important to note that you make the withdrawals on your contributions. This is not on your earnings, if you are younger than 59 ½. Let’s say you have contributed $50,000 to your account. However, your account has grown to $85,000. If you have had your account for at least five or more years (and you are not 59 ½ or older), you can withdraw up to $50,000 without penalty. While this is not recommended, this is a great advantage of the account if you were to ever run into a financial pinch and really needed some extra cash.

As of January 2025 the Roth IRA contribution limit is $7,000 for people under 50 years old. The limit for people 50 years or older is $8,000. If you are under 50 years old you can contribute up to $583.33 a month towards your Roth IRA account. When you are 50 years or older you can contribute up to $666.67 a month . If you are able, it is always a good idea to max out your Roth IRA account every month. Your money will only grow and you will be taxed on the lessor contribution rather than the greater withdrawal.

Advantages:

• You can open up a Roth IRA at anytime in your life and by yourself. You do not need an employer to do so.
• Once you have had the account for 5 or more years, you make make withdrawals on your contributions without penalty.
• Your contributions to the account are made with after-tax income.

Disadvantages:

• The maximum amount you can contribute is $7,000 a year ($8,000 if you are over 50).
• It takes time to see significant growth on your contributions.
  • Not necessarily recommended if you are starting to save for retirement later in life.

401(K):

A 401(K) is a retirement plan sponsored by an employer. A big difference between the Roth IRA and 401(K) is that 401(K)’s are funded with pre-tax income. This is simply the financial way of saying that you are not taxed on your 401(K) until you make withdraws from the account during your retirement. The disadvantage of this is that you are likely to be in a higher tax bracket during your retirement than when you were making contributions to the account. This is especially true when you first started out in your career. 

As of January 2025 the 401(K) limit is $23,500 a year. It is important to note that this is your individual limit. Your employer match does not count towards your 401(K) limit. An average 401(K) plan in the U.S. is that of an employer matching anywhere between 4% and 6% of an employee’s salary. A 4% – 4.5% is considered a ‘good’ match. Anything matching 6% or above being considered a ‘great’ employer match. 

Unfortunately, you cannot withdraw from your 401(K) until 60 years old without penalty. If you choose to draw on your account before you are 60 years old there is a 10% penalty. Further you will also have to pay an income tax on these early withdrawals. If you were to withdraw $10,000 from your 401(K) account (before 60 years old), you will really only receive $9,000 when it is all said and done. You will also have to pay an additional income tax on the full $10,000 amount. To avoid any penalties and to maximize the amount of money you receive, the best thing you can do is wait. Do not make any withdrawals from your 401(K) account until you are 60 years or older.

Advantages:

• The maximum amount you can contribute is up to $23,500 a year.
• Your employer matches your contributions (up to a certain percentage, dependent on the employer program), this is essentially ‘free money’.

Disadvantages:

• Cannot withdraw any money until 60 years old without penalties
• You can only open up a 401(K) with your employer – cannot start an account until your first full time career / job
• Your contributions are made with pre-tax income. You get taxed as you pull money from your account.

Conclusion:

It is important to note here that you can have both of these account options working for you at the same time. Since a Roth IRA is an individual retirement account, you can open it up for yourself at any point in time in your life. This is true even if you already have a 401(K) with your employer. When it comes to investing, it’s always a good idea to have your eggs in multiple baskets. Remember the best thing you could’ve done when it comes to investing was to start investing yesterday. However, the second best option is to start today! The magic of investing comes from compound interest. This is true in all types of investing – whether it is with retirement funds, index or mutual funds, ETF’s, the stock market, and any other kind of investments! Time is your best asset, the sooner you start, the better!

It is important to set a budget for yourself . This budget should not only include saving money every month, but also investing money every month – pay yourself first! You now that you know the core differences between a Roth IRA account and a 401(K). You can (and should) analyze your own financial situation to see which one would be the best fit for you and how to maximize your retirement savings options!