The major differences between a 401(k) and a Roth IRA, which are both popular tax-advantaged retirement savings vehicles – are tax treatment, investment options, and possible employer contributions. It is possible to contribute to both plans, but not with the same dollars.
Named after section 401(k) of the Internal Revenue Code, a 401(k) 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 the 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're known, are subject to income taxes, at the retiree's current tax rate.
As of 2018, the limit for annual 401(k) contributions is $18,500 for those under the age of 50. Those ages 50 and older can contribute an additional $6,000 per year.
To be sure, 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 doesn't directly affect the employee's contribution, but overall, 401(k) contributions from all sources can't exceed $55,000 annually (or $61,000 for employees over age 50).
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. As there is no employer, there is no opportunity for an employer match with Roth IRAs. 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.
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 2018, the maximum annual contribution is $5,500 for those under the age of 50, while those ages 50 and up can contribute an additional $1,000 for a total of $6,500 per year. Individuals who earn more than $135,000 per year (or $199,000 for couples) are ineligible to contribute.
Roth accounts make the most sense for individuals who believe that they will be in a higher income tax bracket when they retire than they are in currently. Obviously, it's better to pay taxes on a smaller percentage on 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 ).