Personal Finance

Traditional 401(k) vs. Roth IRA: Which One Wins?

Expertise: Real Estate Investing Basics
16 Articles Written
Hand Putting A Coin Into Piggy Bank In Front Of Blackboard Showing Graph

Did you know the average American has only $96,000 saved for retirement? This amount is not nearly enough!

Want more articles like this?

Create an account today to get BiggerPocket's best blog articles delivered to your inbox

Sign up for free

It’s never too late to start saving, but it’s better to start preparing for your retirement as early as possible.

Traditional 401(k)s and Roth IRAs are both very popular types of retirement accounts, and hopefully after reading this article, you’ll know which one is better for you. Or maybe you’ll want both!

What Is a Traditional 401(k)?

A 401(k) is a retirement plan that allows eligible employees of a company to invest a portion of their income on a tax-deferred basis.

Pros and Cons of 401(k)s

Pros:

  • Tax Deferral – The money you invest is pre-tax, so your contribution decreases your taxable income.
  • High Contribution Limits – $19,000 per year if 49 years old or younger. $25,000 if 50 or older. Employer contribution does not count toward the limit.
  • Matching – Employers are allowed to match your contribution.
  • Withdrawal – Early withdrawal without taxation is allowed in the event of financial hardship or becoming totally disabled.
  • Rollover – You can roll over your 401(k) to a traditional IRA or Roth IRA after leaving your employer or reaching retirement.
  • Loan – If your employer permits it, you can take out loans up to 50 percent of your vested balance or $50,000, whichever is less.

Cons:

  • Distribution Tax – The distribution will count as additional income and will be taxed. The amount of tax is based on your income tax rate at the time, so the rate may be higher or lower than your current tax rate.
  • Limited Flexibility – Limited number of funds to invest in.
  • Taxable Income Upon Withdrawal – Early withdrawal is taxed up to 20 percent plus a 10 percent penalty if you withdraw before age 59.5.
  • Required Withdrawals at Age 70.5 – Plan holder must start receiving distribution by age 70.5.
  • Loan Payback – Loan must be repaid within five years and you need to pay interest on the loan; however, the interest payments are added to your investment balance. The interest rate is comparable to the rate charged by lending institutions. You must repay your loan through payroll deductions.

Related: Growing Your 401k vs. Liquidating it to Invest in Real Estate: What’s More Profitable?

What Is a Roth IRA?

A Roth IRA is a retirement account that allows a person to set aside after-tax income up to a specified amount each year for investments.

Pros:

  • Tax-Free – The distribution does not count as additional income and is not taxed. This tax treatment also applies to a Roth 401(k).
  • More Investing Options – You can easily open up an IRA account with various financial institutions, such as Vanguard and Fidelity. You also have more investment options (i.e., more variety of mutual funds and the option to purchase stocks or investment properties). To purchase investment properties, you need to open up a self-directed Roth IRA, and the account takes about 10 business days to set up. Any capital gains for this account are also tax-free.
  • Does Not Require Withdrawals at Age 70.5 – Unlike a 401(k), the account holder isn’t required to withdraw during his/her lifetime; however, a required minimum distribution (RMD) is required after the plan holder’s death.

Cons:

  • Limited Annual Income – Limited to people with modified adjusted gross income (MAGI) under $137,000, or $203,000 if you’re married, filing jointly. High income earners can still invest in Roth IRAs by converting a traditional IRA to Roth, but this conversion will be taxed at your regular income rate.
  • Post-Tax Contribution – Unlike traditional IRA or 401(k), post-taxed dollars are used for Roth IRA and Roth 401(k) contributions.
  • Taxable Income Upon Withdrawal – Early withdrawal before age 59.5 is taxed as additional gross income plus an additional 10 percent tax penalty. However, only the capital gains are taxed. The contributions were already taxed once, so it’s not subject to early withdrawal tax.
  • Low Contribution Limit – Annual contribution limit is $6,000, or $7,000 if you’re age 50 or older.

Similarities and Differences Between 401(k)s and Roth IRAs

The Venn diagram below illustrates how these two types of retirement accounts are similar and how they differ, with the overlapping part of the circle representing that which they have in common.

Theoretical Earnings for the Traditional 401(k) and Roth IRA

Below is what each type of account would amount to assuming the following:

  • Tax Rate: 25%
  • Annual Investment: $6,000 ONLY for both retirement accounts, even though 401(k) has a higher contribution limit. The annual investment starts at age 21 and stops at age 60.
  • Annual IRR: 8%
  • 401(k): Tax-deferred savings are invested in a mutual fund that also generates 8% annual return, and the investment is not sold until age 60.
  • Employer Contribution: The 401(k) projection does not take employer contribution into account. You should always take advantage of the employer contribution. This projection comparison is for the unmatched contribution.
  • Withdrawal: All investments are withdrawn at age 60 to avoid early withdrawal penalties.

A) Scenario 1 – Same Tax Rate at Age 60

In this scenario, the difference between the traditional versus Roth distribution is $104,917.89 (in favor of the Roth account).

B) Scenario 2 – Higher Tax Rate at Age 60

In this scenario, the difference between the traditional versus Roth distribution is $314,753.67 (in favor of the Roth account).

C) Scenario 3 – Lower Tax Rate at Age 60

In this scenario, the difference between the traditional versus Roth distribution is $104,917.89 (in favor of the traditional).

Related: How to Use Real Estate to Retire MUCH More Comfortably Than Your 401k Would Allow

Based on the results of the first scenario, where one would be subjected to the same tax rate at age 60, a Roth IRA is a better investment than a traditional 401(k). The Roth IRA’s distribution at age 60 is greater by almost $105,000, and this difference increases as the future tax rate increases.

On the other hand, if the expected tax rate at age 60 is lowered to 15 percent, then the traditional 401(k)’s distribution would be greater by nearly $105,000 instead.

So… Traditional 401(k) or Roth IRA?

It’s better to invest in a Roth IRA early on in your career while your tax rate is still relatively moderate. As time goes on and you start earning more income, your tax rate will increase. At that point, consider allocating more money to your traditional 401(k) to reduce your taxable income.

It’s difficult to predict what your tax rate will be in the future, so I recommend making the decision based on your current tax rate. Nevertheless, it’s recommended to take advantage of your employer’s contribution. It’s free money after all! No tax advantage can beat this.

Even though your current MAGI is greater than $137,000, you can still invest in a Roth IRA through the backdoor method, which is essentially converting your traditional IRA to a Roth IRA.

Lastly, instead of a traditional 401(k), you can choose to invest in a Roth 401(k), which gives you the same tax treatment as a Roth IRA, meaning that the distribution is not taxable. Unlike a Roth IRA, a Roth 401(k) is available to individuals earning more than $137,000 MAGI, as well.

Which retirement accounts do you currently own? Do you plan on switching to something else after reading this article? If so, which type?

Let me know your thoughts in a comment below!

Jay Chang, a civil engineering graduate from UCLA, is an active investor, developer, writer, and Founder of Hestia Capital. He moved to Phnom Penh, Cambodia in 2020 and is now investing in real estate and other business opportunities in both the U.S. and Cambodia. Before starting his own business, Jay worked at CIM Group and Pankow Builders as a construction manager. He's also part of the real estate investment group called MultifamilyMasters. Jay aspires to develop projects that bring the communities together. When he has free time, he travels, plays basketball, and snowboards.
    Joshua Metayer from Burlington, Vermont
    Replied over 1 year ago
    Hi Jay, You do not need to take RMD from Roth IRA, unlike other qualified assets (401, Traditional IRA, etc.). Also I would be interested to see your math on a tax adjusted bases. As an example $6,000 initial investment into Roth IRA vs. $8,000 in 401k.
    Terry Lowe
    Replied over 1 year ago
    In our scenario, we received a 4% contribution by the employer. That makes a big difference!
    Jay Chang Developer from Los Angeles, CA
    Replied over 1 year ago
    Hey Terry, You're absolutely right. In my opinion, everyone should take advantage of employer's matching contribution! It's free money after all. The projection is for the portion of Traditional IRA that exceeds the matching threshold. For example, an employee might allocate 4% of his/her pretax income to 401(k) to receive the full matching contribution, but put additional money in Roth IRA instead of the traditional 401(k). I should've noted this in the article to be clear. Definitely keep taking advantage of your employer's 4% contribution!!
    Brian Shade
    Replied over 1 year ago
    This is a horrendous error filled article, starting with the false claim about Roth RMDs, which don't exist. Please take it down. You're misleading the public. Thank you.
    Jay Chang Developer from Los Angeles, CA
    Replied over 1 year ago
    What are some of the other errors besides the Roth IRA RMD? Please let us know, the info can be revised.
    Derek Clark Rental Property Investor from Eagleville, Tennessee
    Replied over 1 year ago
    Only gains on Roth IRA are taxed on early withdrawal for one. You can withdraw your contributions tax and penalty free because you already paid taxes on them. It’s one of the major benefits to a Roth IRA.
    Michael Beur from Georgetown, Texas
    Replied over 1 year ago
    I agree with Brian. Lots of miss information on this article.
    Nathan Schloegl
    Replied over 1 year ago
    I agree, lots of misinformation here. Your Venn diagram illustrating the similarities is horribly wrong. The RMD’s for Roth’s was already mentioned. However, stating there are taxes on early withdrawals is somewhat inaccurate as well. You are NOT taxed on your contributions if you pull them out before 59.5. You are only taxed on the earnings. I suggest you do some more research before posting such an article that will mislead many people.
    Jay Chang Developer from Los Angeles, CA
    Replied over 1 year ago
    Great point Nathan. I mentioned that there is tax on early withdrawal, but I didn't specify that the tax amount is different. I'll make note of that on the revision. Thanks for the help! Anything else you see that's wrong with the Venn diagram? Or is it just the 2 items, clarification on early withdrawal and the RMD.
    Ashte Collins from Bowie, Maryland
    Replied over 1 year ago
    Why is there no info on the Backdoor Roth IRA? This is a glaring omission that needs to be addressed along with the RMD issue mentioned above.
    Jay Chang Developer from Los Angeles, CA
    Replied over 1 year ago
    Hey Ashte, I left out this information because my main goal was to compare the returns between Traditional 401(k) and Roth IRA, but backdoor Roth IRA is a valuable information to add. The reader should know that there is a way to get around the income limits through the backdoor method. Additionally, I wonder if you agree with me that high income earners should put their money in traditional IRA and 401(k) instead to reduce their taxable income as much as possible, because their tax rates are higher than average people.
    Matthew Adair Rental Property Investor from Chicago, IL
    Replied over 1 year ago
    Certainly agree that we don't want misinformation out there. Jay, I give you credit for trying to encourage young people to save for retirement. If this article gets one young person who wasn't saving for retirement to start, it was worth it.
    Christopher Vasquez
    Replied over 1 year ago
    Jay, I think discussing this topic is important. However, it might have been better to do a comparison between Traditional 401(k)'s and Roth 401(K)'s for the entire article. It is not really a fair comparison with the contribution limits between a Roth IRA and a Traditional 401k being so different. Also, you may want to edit the article for your contribution limits on your Roth IRA... If you are a single filer the contribution limit is $122,000 - $137,000 and married filing jointly $193,000 - $203,000. I believe you had $135,000 for a single filer and $199,000 for married filing jointly. Hope this helps. Chris
    Jay Chang Developer from Los Angeles, CA
    Replied over 1 year ago
    Hi Christopher, the correct amount should be 137,000 for single and 203,000 for joint. The 122,000-136,999 you mentioned is the MAGI bracket where the contribution limit begins to phase out. Great catch.
    Nate Richards Investor from Tallmadge, Ohio
    Replied over 1 year ago
    The biggest and most egregious error is the fact that you invested 25% MORE into the Roth IRA for the life of the calculation. The IRA should have 25% LESS every year to account for the taxes.
    Jay Chang Developer from Los Angeles, CA
    Replied over 1 year ago
    Nate, if you take a look at the projection data for traditional 401(k), you'll notice that there is additional investment on the side through a mutual fund. This is because investing in traditional 401(k) reduces your taxable income and your tax, so you'll have additional income to invest with. The additional income you possess is equal to the tax that you saved, which is 25% of your investment. This is why the projection for 401(k) has additional annual contribution than the projection for Roth IRA. This 25% difference that you mentioned was taken into account.
    Alan Hernandez from Columbus, OH
    Replied over 1 year ago
    Initially this article confused me but then it was just wrong. First, why Traditional 401k vs Roth IRA? Do 401k vs IRA. Then break down differences between in both of Roth vs traditional. No mention of self directed options either. More importantly though, this info on withdrawals and RMD is just straight up false. Sorry, but this is just bad and should come down.
    Michael Baum from Olympia, Washington
    Replied over 1 year ago
    Also, in regards to taking out 401(k) funds if you become disabled, it is not tax free. The exemption for a permanent disability only exempts the 10 percent early withdrawal tax penalty of 10%, not any income taxes due on the distribution. That includes federal and applicable state taxes. I know this for a fact as I had to do this to pay medical bill when I became permanently disabled in 2011.
    Joe Coyne Investor from Cleveland, OH
    Replied over 1 year ago
    Roth IRA's do not have RMD's. Otherwise, good article. I ALWAYS recommend to first contribute to 401k up to the match, and THEN contribute as much as you can to a Roth IRA. If you can do the full $6k then return to adding more to your 401k. If you have the option to contribute to an HSA, I would also max that out if possible - as that is the best of both worlds - tax deductible and tax free growth and withdrawals.
    Jay Chang Developer from Los Angeles, CA
    Replied over 1 year ago
    Thanks for all the helpful feedback. I have updated the article to address the errors and the clarifications needed.
    Melissa L Whigham
    Replied over 1 year ago
    Loved the article Jay, now i can invest more and explain better to my family! Melissa
    William Carpenter from Wichita
    Replied over 1 year ago
    I think it also worth noting that IF you take a distributions of earning from a Roth before 59 1/2, it is subject to the 10% penalty as well. Additionally, from a technical perspective, if you have a Roth 401(k), and it is still maintained within an employer plan, it is subject to the RMD requirements at 70.5. You can roll the funds to an IRA to get around this, but the rule does still exist.
    William Carpenter from Wichita
    Replied over 1 year ago
    I also think if we are going to be technical on the Roth taxability, it’s not capital gains. It’s earnings. I think from a technical standpoint, while you may have “capital gains” within a retirement account, no matter the nature of investment (401K. IRA, Roth), taxable “earnings” are subject to ordinary income rates, and not the lower capital gain rates. I think it could be confusing to someone reading and does not fully understand the difference.
    Jonathan Berk
    Replied about 1 year ago
    Isn't this an unfair comparison because the "Tax Defer Savings" line of the 401K model should be $2,000 instead of $1,500? If the post-tax contribution in the Roth IRA scenario is $6,000, then that means you had to use $8,000 of your pre-tax earnings to do it (at 25% tax rate). So the fair comparison to the 401K should be $8,000 pre-tax contribution ($6,000 pre-tax contribution + $2,000 tax defer savings), not the $7,500 used in this 401K example. When you run it that way, the "A) Scenario 1 – Same Tax Rate at Age 60" comparison will show the outcomes for 401K and Roth IRA are completely identical. Let me know if I'm missing something -- would love to understand this better if I am.