Roth IRA or 401(k): Which One Is Right For You?
Editor’s Note: This guide was originally published in 2020 and has been updated in December 2023 for accuracy.
I hear it all the time, “Should I invest in a Roth IRA or a 401(k)?” To help you answer that question, first we need to know what they are and what some of their benefits are. From there, I will make several suggestions to help you think about your own situation. Ultimately, the answer will largely depend on your current tax bracket, your future retirement tax bracket, and when you plan on retiring. One thing I will say is that no matter how high your income is, it’s possible for you and your spouse to each use both!
Before I dive into the details, note that I will use the following terms quite often, so it’s important to know the difference:
Contributions refer to money you put in
Earnings refer to your gains
Pre-tax dollars is income before taxes are taken
Post-tax dollars is income after taxes are taken
Tax-deferred means you pay taxes later, when you withdraw the money from a retirement account, hopefully when your tax bracket is lower
Now that we got that cleared up, let’s compare the Roth IRA and 401(k).
Roth IRA vs 401(k)
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As you can see, the major benefit of a Roth IRA is that earnings grow tax-free! The major benefit of a 401(k) is that you can lower your tax burden today and pay taxes later (hopefully when your tax bracket is lower). The other major benefit of a 401(k) is called a company match, if offered by your employer.
401(k) Employer Match
If your employer offers this benefit, I strongly suggest contributing up to the maximum amount your employer will contribute. For example, let’s say your employer offers a 100% company match of up to 3% of your gross salary (that is, your pre-tax salary) and that your gross salary is $100K. If you contribute 3% of your gross salary into your employer-sponsored 401(k) plan, then your employer will also contribute 3%.
Your gross salary: $100K
Your contribution: 3% of your gross salary = $3000
Employer contribution: 100% match up to 3% of your $100K gross salary = $3000
Total balance in your 401(k): $6,000
Every dollar you put in (up to $3000, in this example) automatically gets doubled thanks to your employer and makes an immediate 100% ROI (return on investment)! I can’t think of an easier way to double your money than that, which is why I believe contributing to a 401(k) up to the company match should be your highest priority.
As illustrated above, the dollar amount an employer contributes to your 401(k) is based on a percentage your employer picks and your salary.
Employer contribution = Match percentage x Your salary
So the more you make, the more your employer contributes to your 401(k). That sounds great if you’re highly-compensated, but that’s not fair to lower-paid employees. So in an attempt to level out the playing field, the IRS imposes a max salary that can be used when calculating the employer match dollar amount. In 2024, that max salary is $345K. So even if you make $500K per year, your max employer contribution will be calculated using the $345K salary cap. Using the previous formula:
Employer contribution = Match percentage x $345K (not $500K)
Lastly, let’s illustrate just how high the highly-compensated employee’s total 401(k) contribution would be if they maxed out their 401(k) plus the employer match:
Gross salary: $500K -> Salary cap reduces the match calculation down to $345K
Employee contribution: The 401(k) max if under 50 = $23,000
Employer contribution: 100% match up to 3% IRS max of $345K = $10,350
Total balance in your 401(k): $33,350
Roth IRA
After contributing up to your 401(k) company match limit (or if your employer doesn’t offer one), consider a Roth IRA because all earnings grow tax-free, compared to 401(k) earnings that grow tax-deferred. Additionally, a Roth IRA allows you to withdraw any of your contributions from the account at any time without penalty. I definitely don’t advocate for any early withdrawals since that would hurt your (tax-free) earnings, but the no-penalty aspect of a Roth IRA is certainly a nice backup option should you need your contributions before 59 ½ (e.g. emergencies, early retirement). Consider this: If you currently invest through a basic, individual brokerage account at a brokerage firm like Fidelity or E-Trade, then you might as well invest through a Roth IRA instead so that your earnings grow tax-free!
In the Roth IRA vs 401(k) comparison table above, I mentioned that the 2024 income limit is $161K for single filers and $240K for married filers. However, I should note that for single filers who make between $146-161K and married filers who make between $230-240K are subject to phase-out contribution limits. For example, a single filer under 50 years old who makes $152K can’t contribute up to the $7,000 max. Instead, their contribution limit is phased-out and can only contribute a fraction of the maximum. Thankfully, there’s a workaround to that problem called a Backdoor IRA!
Backdoor IRA
Earlier, I mentioned that no matter how high your income is, it’s possible for both you and your spouse to use a Roth IRA and 401(k). 401(k)s have no income restrictions, only contribution limits, so that’s a simple one. But the IRS prevents single filers and married filers who make $161K or $240K or more, respectively, from contributing to Roth IRAs (see contribution limits for details). However, through a process called a Backdoor IRA, you can convert a retirement account like a Traditional IRA or 401(k) into a Roth IRA account. The term Backdoor IRA is just a process, not an actual account type. As of 2024, you can do this conversion no matter what your income is, but it’s possible the IRS will close this loophole in the future. Note that doing a conversion can have tax consequences and restrictions on the converted money, so do your homework. Check out my step-by-step guide on how to do a Backdoor IRA using Fidelity!
Suggestions & Guidelines
For some, maxing out both a Roth IRA and a 401(k) is a no-brainer. But for many others, partial contributions to both will help maximize their benefits from each and, therefore, it’s important to consider the order in which to contribute to them. Typically, I recommend the following:
Contribute up to your employer’s company match limit, if applicable
Max out your Roth IRA. To avoid the contributions from being phased-out, use the Backdoor IRA conversion if your 2024 income is above $146K or $230K for single or married filing jointly filers, respectively.
Contribute the remaining amount of your 401(k) up to the annual limit
It’s also important to know that 2024 income limits and contribution limits to both accounts depend on your age, as well as your filing status. See Roth IRA contribution limits and 401(k) contribution limits for details.
I obviously don’t know how much money you spend versus save annually, nor do I know the cost of living in your area or your current vs future tax brackets. So take my suggestions merely as high-level guidance. For example, if you believe your income will be higher when you retire or if you’re planning on retiring early, before 59 ½, perhaps you’ll want to avoid maxing out your 401(k). If you plan on retiring outside the U.S., 401(k) withdrawals will still be taxed as normal, but you may have to transfer in relatively small amounts over time and pay taxes in the foreign country. Ultimately, it’s up to you to understand your current and future financial situation, especially from a tax bracket perspective.
Everything considered, if you can afford to max out both, then consider both. For others, you usually want to contribute to a 401(k) up to the company match amount first, then max out a Roth IRA, and lastly finish maxing out your 401(k). For most, it’s a matter of prioritizing the money you’ve earmarked to invest into one retirement account or the other. Deciding which one(s) to use really depends on your current and future tax brackets, as well as your retirement goals. If you need further assistance digging into this, feel free to reach out to me via my Contact page!
Edited in December 2024: Check out my step-by-step guide to do a Backdoor IRA using Fidelity!
Edited in December 2024: Check out my step-by-step guide to do a Mega Backdoor Roth using Fidelity!
