Roth IRA vs 401k – What’s the Difference?

If you have a 401k at work, you can still have your own Individual Retirement Account.

The Roth IRA in particular has several distinct advantages (but disadvantages, too) compared to the workplace plan.

Lets compare the Roth IRA vs 401k and see what the differences are.

Roth IRA Overview

As the name implies, the Individual Retirement Account requires no participation from an employer. It is solely managed by the individual (possibly with assistance from a professional investment advisor).

Not all employers offer a 401k or other retirement plan. So the IRA is able to fill this gap if it exists.

The Roth IRA has other advantages, too.

For example, it’s very easy to open with a minimal amount of paperwork at an online brokerage firm. It also offers tax-free withdrawals.

This is possible because contributions are made with after-tax dollars.

Although the IRA circumvents the need for an employer, it does have one caveat. You have to have earned income to contribute. Dividends, interest, and income from rental properties don’t qualify as earned income.

401k Overview

The 401k is available only through an employer. If you’re self-employed, you can open one on your own because you’re an employer. Be aware, however, that opening a 401k involves a lot more red tape than opening a Roth IRA.

The great advantage of the 401k is that you can make large contributions and deduct them from your income. And the employer can make its own contributions to match yours, further growing your nest egg.

And just in case you’re wondering—yes, you can have both a 401k and a Roth IRA.

Fees

In days of old, Roth IRA’s had annual fees and minimum balance requirements.

Today, it’s quite easy to find an online discount broker offering the account without fees, minimums, or commissions.

Although it has become a fee-free account, some brokers may impose charges in special cases. For example, if you make a withdrawal from your E*Trade IRA before age 59½, the broker will charge $25.

401k’s are a completely different story. Typically, an employer will contract with an investment firm that manages the 401k accounts professionally.

This leads to several fees, including:

  • Plan administration fees: These cover the cost of managing the bureaucracy of the accounts. Usually, it’s a flat fee or percentage of account balance, per year.
  • Mutual fund fees: Some 401ks will restrict your investments to certain mutual funds that have high expense ratios.
  • Miscellaneous fees: These are for services like rolling over a 401k into an IRA or taking out a loan.

If you’re self-employed, it’s possible to bypass these fees by opening a solo 401k. Since you’re the boss, you can create the same fee structure your Roth IRA has.

Contributions

The gap between the 401k and the Roth IRA gets wider here. One of the primary differences between the two retirement accounts lies in the amount you can contribute.

For 2020, the maximum contribution to a Roth IRA is $6,000. For the 401k, the number is $19,500. And that’s just the employee’s part.

The employer can contribute up to $37,500, bringing the grand total to $57,000. That’s nearly ten times the limit on the Roth IRA.

And then there’s the catch-up contribution. Once you hit 50 years old, you can actually exceed these limits by a thousand or more dollars.

Salary Limits

To actually make a contribution to a Roth IRA, you have to make less than $139,000. This is for tax year 2020 and assumes you file single. To qualify for the full $6,000 contribution, you have to make less than $124,000.

If your tax return is married filing jointly, the phase-out range is $205,000 to $196,000.

401k plans don’t have salary caps. Instead, the IRS puts limits on what are known as highly compensated employees (HCE’s).

Basically, contributions by HCE’s can’t be excessive when compared to contributions by non-HCE’s.

These rules will kick in if you own more than 5% of the company or make more than $125,000 per year.

Matches

As already mentioned, the Roth IRA has no employer; so obviously, there’s no employer match. A 401k may or may not offer an employer match.

If it does, matches are not permitted beyond $285,000 of salary.

Taxation

Here’s where things get really interesting. Because contributions to a Roth IRA are made with post-tax dollars, the IRS doesn’t tax the account at all. There are no taxes during the lifetime of the account or at withdrawal.

This of course assumes that you play by the rules and don’t make any withdrawals before age 59½. The account also needs to be at least 5 years old when you start making withdrawals.

Except when it doesn’t. If you’re withdrawing an amount equal to or less than your total contributions, it’s a straightforward policy. The account can be any age, you can be any age, and there are no fees and no taxes.

Because the IRS gives you a tax deduction on 401k contributions, it wants a slice of the pie when you make a withdrawal. The tax is equal to your marginal tax rate during the year of withdrawal.

Withdrawals

Speaking of withdrawals, you can always withdraw your contributions from a Roth IRA at any time. There are no taxes or penalties. This is one of the account’s attractive features.

It’s only when you withdraw earnings that you have to worry about account age and your age.

Withdrawals from a 401k can begin at 59½ with no penalties. Before that age, it’s an extra 10% penalty on top of the regular tax that is assessed. The same rule applies to early withdrawals of earnings from a Roth IRA.

Required Minimum Distributions

Remember when I said that Uncle Sam wants a slice of the 401k pie? Well, he doesn’t have a lot of patience. He imposes this little rule, known as the RMD rule.

It says you have to start making withdrawals from your 401k no later than age 72. If you don’t, you get hit with a 50% excise tax. Ouch.

The Roth IRA has no required minimum distribution rule, another advantage.

Rolling Over a 401k into a Roth IRA

Because of the Roth IRA’s lack of an RMD rule, some older folks like to roll over 401k assets into a Roth IRA. This is perfectly legal of course. But when you do this, the IRS considers the withdrawal from the 401k to be, well, a withdrawal.

So you’ll be hit with a tax bill at your marginal tax rate that year. If that rate is lower than when you put the money into the 401k, you managed your finances wisely.

Day Trading in a 401k or Roth IRA

Until you actually get ready to make withdrawals during retirement, you can trade in your retirement accounts.

This is especially true of the IRA. Some employers may not permit trading of stocks, ETFs, options, and other assets in a 401k. You can trade these instruments with a self-employed 401k, though.

It’s possible to open an IRA with limited margin trading capability. Generally speaking, IRA’s don’t have margin.

But some brokers, like TD Ameritrade and Interactive Brokers, will let an IRA trade with unsettled funds. This is what is meant by an IRA margin account.

Although shorting is not allowed in a 401k or Roth IRA, it is possible to buy puts. This is a bearish strategy. You can also buy inverse ETF’s, another bearish bet.

Let’s compare the main differences…

Roth IRA Pros

  • No employer needed
  • Easy to set up
  • No required minimum distributions
  • Account grows tax free

Roth IRA Cons

  • Low contribution levels
  • No tax deduction
  • No employer match
  • Maximum income levels

401k Pros

  • High contribution levels
  • Usually has an employer match
  • Contributions are tax deductible
  • Account grows tax deferred

401k Cons

  • Required minimum distributions kick at in 72
  • No employer matches above salary limits
  • Withdrawals are taxable

Bottom Line

Both 401k’s and Roth IRA’s offer advantages and disadvantages in a variety of situations.

Day traders won’t get the full trading experience they enjoy in taxable accounts. But they can capture some important tax advantages.

Credit: Warrior Trading

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