If you aren't familiar, both are tax-advantage retirement-savings vehicles. Let's look at the differences.
A 401(k) is an employer-sponsored plan (if you own a small business, obviously you are the employer) that allows you to invest pretax dollars in the plan. The employer may or may not match a portion of those contributions. You don't get taxed on your contributions -- or any earnings -- until you start making withdrawals when you reach retirement age. That means your savings grow tax-free.
And since you put pretax dollars in a 401(k), that means you owe less in income taxes every year you make contributions. (If you gross $60,000 and put $3,000 in a 401(k), you owe income tax on only $57,000.)
A Roth IRA is a variation of a traditional IRA. With a traditional IRA you contribute pretax dollars; with a Roth you invest income that has already been taxed. While that sounds like a disadvantage, there is one major benefit: Earnings in the account do not get taxed -- and when you start making withdrawals at retirement age, those withdrawals are not subject to income tax.
So you do get taxed on the money going in, but you don't get taxed on the money coming out.
Which Should You Choose?
In a perfect world, both: The more money you can invest in retirement savings plans, the more money you will someday have at your disposal.
But if you have to choose ...
If you work for someone else, always, always, always contribute to a 401(k) plan up to the amount that maxes out the employer match. If your employer will match, say, 50 percent of your contributions up to 5 percent of your pay, contribute 5 percent of your pay. Your employer will kick in an extra 2.5 percent.
That's free money.
Never turn down free money.
Then contribute to a Roth IRA. While you will have to pay taxes on the money before you invest it, you will never pay taxes on that money -- or on the earnings it generates -- again.
The younger you are, the better that works out for you. If you're 30 and you leave the money in your Roth IRA until you reach retirement age, even relatively modest annual returns will add up to a tidy sum.
A tidy sum you can withdraw tax-free.
And keep in mind you don't have to make required minimum distributions with a Roth; only when you pass away do your heirs need to do something with those funds. (That's when it can get somewhat complicated, so talk to an estate planning attorney if your goal is to pass on your Roth to your heirs.)
Granted your 401(k) will also be growing tax-free, but when you start making withdrawals, you'll be taxed on that income.
But What if You Own a Small Business?
If you set up a 401(k) plan for employees, roughly speaking you must offer the same plan benefits to your employees as you receive. So you may not want to establish a huge match plan.
But if, like me, you are your only employee, then you can feel free to match to your heart's content.
That's what I do. My plan is set up to match 100 percent of employee contributions, which means I match 100 percent of my contributions. Since I'm over 50 and can make "catch up" contributions, I am allowed to contribute up to $24,000 a year as an employee (if you're under 50, the annual limit is $18,000), and my employer (me) can match up to $24,000 a year.
That means I can potentially put $48,000 a year in retirement savings in a 401(k) alone. (Employee and employer contributions can't be greater than the individual's income, and can't be over $55,000 in total. Which means you can, if applicable, kick in an extra $7,000 in profit sharing.)
And then you can still contribute to a Roth IRA. Even though you can't make contributions if your income level is above $135,000 if you file as single or $199,000 if you file married jointly, you can still do a Roth conversion. In simple terms, you contribute post-tax dollars to a traditional IRA... then immediately file a form to convert that IRA to a Roth IRA -- and boom: You've contributed to a Roth.
Let's Sum Up
- Always contribute enough to a 401(k) to max out the employer match. Never turn down free money.
- Then contribute to an IRA. If you're close to retirement age and your current tax bracket is significantly higher than the tax bracket you expect to be in when you retire, invest in a traditional IRA. Otherwise, contribute the maximum amount possible to a Roth IRA.
- Then go back to your 401(k). If you're getting the full employer match and you've maxed out the amount you can contribute to a Roth IRA and you still have money available to save, sock it away in a 401(k). You'll save money on your taxes now, and your earnings will grow, tax-free, for years to come.
Of course your individual needs -- and goals -- may vary, so make sure you talk to a qualified financial adviser to make sure you make the best decisions for you.