401k vs. Roth 401k vs. Roth IRA

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Matt Soladay

Matt Soladay

When investing for retirement, there are many tax-advantaged accounts to consider, but which accounts do you prioritize contributions to, and in what order? The three accounts I am comparing are 401k vs. Roth 401k vs. Roth IRA, and I have provided recommendations based on two primary variables:

  1. Do you have a Roth 401k available to you?
  2. Are you below the income threshold for direct Roth IRA contributions?

What is the Difference between a Roth 401k and 401k?

The Roth 401k is similar to a regular 401k in that you contribute to it every paycheck. However, the big difference is that Roth 401k contributions are made after-tax, whereas a regular 401k is made pre-tax. Let’s break it down using actual numbers. 

401k example:  You make $110,000 as a single-filer and max out your regular 401k, which results in $90,500 subject to taxes; this is because contributions lower your taxable income since it occurs with pre-tax money. 

Roth 401k example: You make $110,000 as a single-filer and max out your Roth 401k, which results in the entire $110,000 subject to taxes; this is because contributions are made with after-tax money.  

401k vs. Roth 401k vs. Roth IRA

The 401k example is left with more net income for the year because those pre-tax contribution dollars are sheltered (deferred) from the IRS. The tradeoff of course, is that this account will be taxed during retirement. In the Roth 401k example, the amount of net income for the year is less because the entire gross income is subject to taxes because contributions are made post-tax. You are essentially choosing to pay taxes today (Roth 401k) or pay them later (401k) in retirement.

This brings us to the million-dollar question:  Which do you choose?  Well…it depends.  

Tax Bracket Considerations

If you expect your tax bracket to be higher in the future, this favors Roth 401k contributions because you would get taxed at your lower rate today and would avoid the higher tax rate in the future since your withdrawals will be tax-free.  The benefit would be the difference between these tax rates.  Let’s say you are at the beginning of your nursing career and are making less than $100,000 a year but plan on becoming a CRNA; you should take advantage of your Roth 401k at your current income level before your tax bracket goes up.

If you expect your tax bracket to be lower in the future, this favors a regular 401k because you would avoid paying taxes today at your higher rate and would make withdrawals during retirement at a lower tax rate.  The benefit would be the difference between these tax rates.

If you expect the same rate of taxation now and in the future, then the differences will not be significant. 

If you have no idea what to expect from future tax rates, have no fear!  It can be difficult to impossible to guess what will happen in the future and how much wealth you might accumulate, so I will have recommendations regarding which accounts to contribute to later in the article. 

What is a Roth IRA?

A Roth IRA is an Individual Retirement Account (IRA) where you make post-tax contributions.  It grows tax-free like all retirement accounts, but when you make withdrawals during retirement, those withdrawals are tax-free.  You also get to avoid mandatory withdrawals (RMDs) at the age of 72, which affects non-Roth retirement accounts.  The other common IRA type is a Traditional IRA, but as explained in the Retirement Account Comparisons article, it is not nearly as valuable for most people, so that won’t be included in my recommendations. 

The Roth IRA is entirely separate from a Roth 401k; although they behave similarly, the contribution limits are different.  Prior to the age of 50, the Roth IRA’s maximum contribution is $6,000, whereas the Roth 401k’s maximum is $19,500.  If you are 50 or older, then it increases to $7,000 and $26,000.  One other important distinction is that a Roth IRA can be opened up at any financial institution that offers it, which is different from a Roth 401k, which must be located with your current employer’s plan.

Roth IRA Eligibility 

A Roth IRA is available to anyone, regardless of your income level.  However, the IRS has set income limits to contribute to a Roth IRA directly and in full.  If you are below this limit, you can set up automatic contributions and max out the account every year.  If you are above this limit, you must perform a ‘Backdoor Roth IRA,’ which involves some extra steps.  More on the ‘Backdoor’ strategy in a future article!

For the purposes of contributing to a Roth IRA, the IRS uses something called your Modified Adjusted Gross Income (MAGI).  In brief, your MAGI is your AGI, plus some exemptions and deductions added back in.  I have more details on how to calculate your MAGI at the end of the article.  Here is a brief chart showing what the MAGI limits are based on your tax-filing status:

MAGI Limits Based On Filing Status

If your MAGI is below those thresholds, you are in the clear and can directly contribute to a Roth IRA.  If you are above those limits, then the ‘Backdoor’ strategy will be for you. The MAGI threshold is the primary determinant of my recommendations below because I personally use it to guide contribution decisions when choosing between a Roth 401k and a regular 401k, if you have the option.

Order of Contribution Scenarios

Now let’s take a look at four different contribution scenarios. As mentioned earlier, the recommendations are based on two primary variables:

  1. Do you have a Roth 401k available to you?
  2. Are you below the income threshold for direct Roth IRA contributions?

Once you have identified which one applies to you, you will see the generalized recommended order of which accounts to contribute to first, second, etc. 

Scenario 1:
Roth 401k available:  Yes
Meet income requirements to contribute directly to a Roth IRA: Yes

  1. Full employer match
  2. Roth 401k
  3. Roth IRA
  4. Taxable brokerage (investment) account

Scenario 2:
Roth 401k available:  No
Meet income requirements to contribute directly to a Roth IRA: Yes

  1. Full employer match
  2. Roth IRA
  3. 401k
  4. Taxable brokerage (investment) account

Scenario 3:
Roth 401k available:  Yes
Meet income requirements to contribute directly to a Roth IRA: No

  1. Full employer match
  2. 401k
  3. Backdoor Roth IRA
  4. Taxable brokerage (investment) account

Scenario 4:
Roth 401k available:  No
Meet income requirements to contribute directly to a Roth IRA: No

  1. Full employer match
  2. 401k
  3. Backdoor Roth IRA
  4. Taxable brokerage (investment) account

Key Points for Order of Contributions

  • Always contribute enough to receive your full employer match regardless of which scenario you are in; most employer matches will result in an immediate 50-100% return on your contribution, which won’t happen anywhere else.
  • After you contribute enough to get your full employer match, you then direct all your contributions to number 2 for your scenario. If you end up maxing out that account, move on to number 3 and contribute there. If you max that account out as well, then move onto number 4.
  • A taxable brokerage or investment account is listed as number 4 for all the scenarios; this is because the account has no tax advantages like retirement accounts, but there are no contribution or income limits, and you can buy or sell anytime you want. People pursuing high savings rate goals will utilize these types of accounts, especially when attempting to achieve early financial independence. 

The most powerful variable to improve your chances of reaching your financial goals is the amount you consistently invest over time.  The benefit of having a clear idea of which accounts to contribute to and in what order is that you don’t have to spend time thinking about it.  You can focus on increasing or maintaining your Savings Rate to reach your long-term goals.

Questions or comments below…

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Your MAGI is your AGI (Adjusted Gross Income) plus certain deductions, and exemptions added back in.  Start by identifying your AGI, which is very easy to do.  It is on line 11 of your 1040 Form (tax return).  If you don’t feel like looking that up and you know your Gross Income from your W2, then simply subtract your deductions (standard or itemized), and that will give you a good estimate at AGI. 
However, if your AGI is close to the income restriction or some of the exemptions and deductions apply to you, you will want to continue on and calculate your MAGI.  Once you have your AGI, add the following deduction and exemption amounts to it, and you will have your MAGI.  Click here to access the IRS’s MAGI worksheet to see what those are.
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J Fernandez
J Fernandez
1 year ago

Great Article!!! Keep it coming… and continue sharing your wisdom Matt!!! 👌

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