401k vs IRA vs Roth IRAThese three types of retirement investment accounts are closely related and, as such, have a lot in common but there are big differences.

If you’re wondering which one is the right match for you, we’ll give you a break down or their main characteristics, differences, and similarities so that you can make the best choice for your situation.

Let’s dive into the features of each kind of account.

What Is a 401(K)?

This account owes its name to the subsection of the IRS code devoted to retirement plans [Subsection 401(K)]. The 401(K) is an employer-sponsored plan, and you designate a portion of your paycheck to invest into this account.

Your investments are made pretax, which means that the money you invest is taken out of your earnings before they are taxed.

One of the most attractive characteristics of this plan is that employers can offer to match your investment up to a certain percentage of your salary. They are investing money for you, and the employer match is not taken into account in the contribution limit.

However, the amount of money that can be entered into your account each year does have a limit.

What Are the 401(K) Benefits?

There are four main benefits to the 401(K) investment plan:

Employer match

You can get your employer to match 50% of your investment for up to 6% of your salary. The exact numbers depend on your employer, but you should look up how much it is and take advantage of the offer.

High contribution limit

For 2020, the account can receive up to $19,500 in investments in the year if you are under 50 years old and up to $26,000 if you are 50 years old or older.

Early tax break

Since your investments are made with pretax money, this reduces your taxable income. You can deduct the contributions you made to this plan in your income tax return.

No limit for income levels

No matter your income level, you can always invest in the 401(K) offered by your employer.

What Is an IRA?

An IRA retirement investment account is most commonly used by people who are independently employed or who work for small businesses that do not offer a 401(K) plan.

Unlike the 401(K) plan, the contribution limit for the IRA in 2020 is $6,000 for people under 50 years old and $7,000 for people 50 years old or older.

One of the bigger disadvantages of both the IRA and 401(K) is that from age 72 and a half, you are obliged to start taking out required minimum distributions.

This means that you must start making withdrawals for the minimum amount established either in retirement or after you turn 72 years old, whichever comes last.

Like the 401(K) plan, investments into IRA accounts are made pretax, so you get a tax break in your income that year because you can deduct the amount invested from your taxable income.

What Are the IRA Benefits?

In some ways, an IRA has similar benefits to the 401(K), except when it doesn’t. Here are the main advantages:

Early tax break

Since your investments are made with pretax money, this reduces your taxable income. You can deduct the contributions you made to this plan in your income tax return.

Choice of investments

Since the IRA is not an employer-sponsored investment account (you have to open and maintain it yourself), the selection of mutual funds you can choose to invest in is much larger.

What Is a Roth IRA?

A Roth IRA is a variant of the traditional IRA accounts. Unlike a 401(K), this kind of plan is entered into directly by an individual, and the employer is not a part of the proceedings. This means that there is no employer match for your investment.

Another difference between the Roth IRA and the 401(K) account—and the main difference between the Roth IRA and the traditional IRA—is that the money used to fund a Roth IRA is after-tax money.

That means that when you begin withdrawals after retirement, that money is not subject to taxation. Also, the gains from the money invested in the account are untaxed while they remain in the account.

You can withdraw Roth IRA contributions at any time without that money becoming taxable or incurring a penalty. However, withdrawing earnings before retirement can incur penalties or be subject to taxes.

What Are the Roth IRA Benefits?

Like the traditional IRA, the Roth IRA has a contribution limit of $6,000 for people under 50 years old and $7,000 for people 50 years old or older in 2020.

However, there are significant benefits in choosing this type of retirement investment account.

Tax-free withdrawals

Since the investments are made with money that has already being subjected to taxation, you can withdraw your contributions at any time with no penalties or taxes.

Gains are not subject to penalties or taxation after retirement.

Choice of investments

Like the traditional IRA, Roth IRAs are set up by the individual without input from an employer. You manage the account yourself, and you can invest in a higher variety of mutual funds.

No RMDs

There are no required minimum distributions (RMDs) in a Roth IRA. This means that you could leave your investments to grow without ever touching them if you wanted.

This is not the case if the Roth IRA account is inherited, however.

What Is the Difference Between 401(K) vs IRA vs Roth IRA?

There are several differences between the 401(K) vs IRA vs Roth IRA.

The 401(K) is the only one that is sponsored by an employer and the only one to offer the possibility of an employer match. The contribution limit is also much higher.

The contributions to 401(K), like the IRA, are made pretax, so the taxable income for the year the contributions are made is lower.

Both the traditional IRA and the Roth IRA are set up directly by the investor, which widens the investment opportunities.

However, the main difference with the 401(K) is that their contribution limits are much lower.

The Roth IRA has the advantage of having tax-free withdrawals in retirement since it is set up with money that has already been subject to taxation.