401(k) Versus Roth IRA: Which Retirement Savings Account Makes Most Sense for You?

When I was 21, my boss asked me to schedule a meeting with human resources after I’d been with the company for three months. My mind raced with possibilities for the meeting: Was I getting let go? Did I do something wrong? As I’d soon learn, the reason for my meeting with Barbara from HR was nothing negative at all. Rather, it was time to go over my options for benefits, including allocations for retirement. Since I wish I’d known then as much as I know now about 401(k) versus Roth IRA accounts, I want to share key differences between the two.

Before diving into specifics, understanding the basics of the importance of saving for retirement is key: The more you can tuck away at a younger age the better, even when things like student loan debt and affording a home may seem more pressing. That’s because compound interest allows your money to grow, and time allows it grow more.

You also may not have access to certain options in the future. For instance, maybe your current employer offers a match program (which means the company contributes a certain percentage of your retirement election to your fund as an incentive)—well, that may change, and then you’ll have missed out on the “free money” of the match program. You might also leave the workforce to focus on your family, or your health may prevent you from working. Circumstances change for any number of reasons, so preparing for retirement in any way you can, as early as you can, is so helpful for financial wellness. So below, learn about 401(k) versus Roth IRA accounts, which are two prominent strategies for saving.

401(k) versus Roth IRA: What’s the difference?

401(k)

A 401(k) is a retirement savings account offered to you at no cost by your employer. Payroll will give a pre-elected amount of your gross pay to the financial institution your company works with, such as Fidelity or Voya, to invest on your behalf. You can choose how you would like your money invested, whether in traditional bonds or having a mix of index funds. As an incentive, the money deposited in the account is pre-tax, making your taxable income (and taxes paid) less as a result.

Roth IRA

A Roth IRA is an individual retirement account (IRA), which is just what it sounds like: a self-funded retirement plan that you contribute to with your income that is already taxed. Just as is the case with a 401(k), with a Roth IRA, your money is invested on your behalf by a financial institution, but you can choose where your money is going and how much. A Roth IRA allows you to have more control over your retirement finances because you’re selecting who receives your money, and not your employer.

SEP IRA and 403(b) Plans

While SEP-IRAs and 403(b) plans are not as widely used (or necessarily available, depending on your employment situation) retirement savings account options, it’s still important to know what they are in order to weigh the pros and cons of how certain career choices may affect your retirement. A SEP-IRA is a simplified employee pension individual retirement account. The IRS created it for entrepreneurs to fund their retirement with their gross income and any employees they may employ. Like an IRA, you are in charge of the company that is investing on your behalf.

403(b) plans are retirement accounts similar to 401(k)s but for non-profit employees and those who work in education. Private employers are eligible and subjected to specific federal and state regulations regarding investing, while tax-exempt organizations are not. With a 403(b), you are still allowed to contribute and have the same opportunities as you would with a traditional 401(k), but instead of a mutual fund company handling the funds, it’s usually an insurance company, which is generally a better option for the employer’s overall fiscal year.

What to consider when choosing between a 401(k) and a Roth IRA

When it comes to 401(k) versus a Roth IRA, there are certain pros and cons to consider. Below, find three key considerations.

Taxes: Do you want to pay taxes on your retirement savings now or later? Since you fund an IRA with taxed money, you do not need to pay taxes on it when you retire. Since you fund your 401(k) with money you haven’t paid taxes on, so you will need to pay when you cash out. Some choose to take advantage of tax breaks now (with 401(k), which doesn’t require you to pay taxes on your allocation, lowering your income tax) while others find themselves taking advantage of it later in life (with Roth IRA, which is already taxed).

Over time, people tend to make more later in life, which leads to them being in a higher tax bracket, and also, tax laws themselves may change (to a degree no one can predict). So, what you need to weigh is your own tolerance for paying what you know now versus what may change—for your benefit or detriment.

Flexibility: Since your retirement accounts are meant to be accessed after you are 59 and a half years of age, you will pay a penalty fee to access any cash in your 401(k) account. But with a Roth IRA, certain qualifying reasons—like buying a first home, paying off medical debt, or funding a higher education opportunity—can be accessed without penalty.

Contributions: You can choose how much you want to put toward retirement, but there are limits to how much money you can invest in these accounts per year. Since you will hypothetically be paying more taxes in your future on a 401(k), you are allowed to invest more per year than you are in an IRA. You can contribute up to $19,500 to a 401(k) while IRAs cut you off at $6,000 per individual (or $7,000 if you’re 50 or older).

Ultimately, your life will change over the years, and so will the opportunities to invest. What’s most important to do regarding saving for your retirement, though, is simply to start.

Athena Valentine Lent is the founder of Money Smart Latina, where Latinas and finance meet. She is also the recipient of the 11th Annual Plutus Award for Best Personal Finance Content for Underserved Communities. When not working, Athena can be found reading a Stephen King book with her main man, a polydactyl cat named Harrison George. 

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