Roth IRA vs. 401(k): How Should You Prioritize Your Retirement Savings?

Note: If passed into law, pending legislation could substantially change Roth IRA regulations after Dec 31, 2021 – especially relating to distributions and backdoor rollovers.

Thinking about the future and retirement can seem so far away, but it’s important to start saving early on in your life to prepare for the most success. 401(k) plans and Roth IRAs are two popular forms of retirement savings. While they may differ when it comes to tax treatment, investment options, and employer contributions, both allow you to grow your savings with certain tax benefits. Let’s take a deep dive into both options to discover which one might work best, and learn how whole life insurance options compare in the Roth IRA vs. 401(k) debate. Knowing the options can help you to increase your wealth.

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What Is a 401(k)?

A 401(k) is an employer-sponsored retirement savings plan. With a 401(k), you can choose to contribute a percentage of your paycheck every month pre-tax. This means all the money you put toward your 401(k) will be deducted before your income is taxed, creating less taxable income for you. However, since you’re getting a tax break upfront, your 401(k) savings will be taxed later. 

Most employers offer some form of a 401(k). Other similar plans include a 403(b) plan which is for tax-exempt organizations like hospitals, public schools, and religious groups and a 457(b) plan which is usually offered by state and local governments and the occasional nonprofit. There is also such thing as a Roth 401(k), similar to a Roth IRA (which we will discuss shortly), in the sense that the dollars invested are after-tax instead of pre-tax.

The best thing about a 401(k) plan is that most employers have a matching program. For instance, say you were to invest 5% of your paycheck every year. Some employers would match that 5%, doubling your total contributions to 10% of your paycheck per year. This isn’t required by law so not all companies will offer 401(k) matching and not all will have the same matching plans, but it’s very likely they have some good options of which you can take advantage. Look into your company’s plan to see what’s available to you.

Advantages of a 401(k) Plan

1. High contribution limits: You are able to contribute up to $19,500 if you’re age 50 or younger before employer matching. This allows you to start saving money quickly. 
2. Employers can offer a match: According to the Bureau of Labor Statistics, the average 401(k) match nets out to 3.5%. This is basically free money that allows you to invest more without having to make all the contributions yourself.
3. Reduces your taxable income: In a 401(k) plan, you are investing money pretax which lowers your taxable income for the year and can provide tax breaks.

Disadvantages of a 401(k) Plan

1. Fewer investment options: Oftentimes, employers hire third-party companies to run their 401(k) plans. These third-party companies determine which fund options are available to invest your money, giving you less control over your investments.
2. Required minimum distributions: At age 70.5 (changing to age 72 under the SECURE Act), you’re required to withdraw a certain amount from your 401(k) savings each year or there will be a penalty fee. There are also fees associated with withdrawing your 401(k) money before age 59.5.
3. Growth is taxed: While you initially don’t have to pay taxes on the money you invest in your 401(k), you will have to pay taxes on it when you withdraw the money. This means that all the money you’ve saved over the years will be subjected to taxes instead of just the growth of the money you invested.

What Is a Roth IRA?

A Roth IRA is a special type of Individual Retirement Arrangement (IRA). An IRA is a type of retirement savings account that doesn’t require an employer to be opened. Any individual can open an IRA account directly with an investment firm. Taking out the middleman often means having more control over your investments because you aren’t limited to the employer’s plan options.

The “Roth” part of a Roth IRA means contributions are made with after-tax dollars. This doesn’t give you a tax break up front, but it does allow for the account to grow tax-free. Withdrawals are also tax-free. This is different from a traditional IRA or 401(k) where contributions are tax-deferred and withdrawals are taxable.

A 401(k) can also come in a “Roth” variation: Roth 401k vs. Roth IRA vs. plain 401k. A Roth 401(k) will have a higher contribution limit than a Roth IRA, and your contributions are after-tax but part of the account will be taxable. This is because employer contributions and the growth on these contributions remain taxable upon withdrawal just as they would be taxable in a typical 401(k) plan.

A Roth IRA can be a nice alternative, especially for those who are self-employed or work for a company that doesn’t offer 401(k) options.

Advantages of a Roth IRA Plan

1. Tax-free growth: Since you invest after-tax dollars into a Roth IRA, the growth of the money isn’t taxed. Plus, you won’t have to pay taxes at retirement when you begin to withdraw the money.
2. More investing options: Like mentioned above, without a third-party company running your investment options, you will usually have more control and choices for investing.
3. No required minimum distributions: You also won’t be fined if you want to leave your savings in your account past age 70.5 (or age 72 based on changes from the SECURE Act) as long as you’ve held the Roth IRA for five years minimum.

Disadvantages of a Roth IRA Plan

1. Lower contribution limits: One difference between Roth IRAs and 401(k) plans is the amount of money you’re able to contribute. For Roth IRAs, you’re only allowed to contribute up to $6,000 each year if you’re age 50 or younger.
2. No employer match: Since Roth IRAs are individual retirement plans, you won’t be able to take advantage of employer matching contributions to grow your savings faster.
3. Income limits: Unlike a 401(k), Roth IRA plans have income limits that affect how much you can contribute based on your earning amount and tax filing status. These limits often differ from year to year so it’s important to check your contribution amounts regularly to see how it’s affected. 

How Whole Life Insurance Compares to the Roth IRA vs. 401(k) Dilemma

While you may not automatically think this way, many people who are looking into Roth IRA vs. 401(k) plans are often great candidates for building wealth with whole life insurance policies. Here are a few reasons why whole life insurance policies could be a great option as you save for the future:

• Whole life insurance premiums aren’t tax-deductible when you pay them, but the cash value grows tax-deferred. This is similar to the tax treatment of contributions to a Roth IRA, but there are no contribution limits when it comes to life insurance premiums. The only life insurance limits depend on income, age, health, and your budget. The death benefit on a life insurance policy is ultimately income tax-free as well. 
• In retirement, you can make withdrawals up to your total premiums paid tax-free. Plus, the entire cash value of the policy will have grown to be more than what you’ve paid in premiums by this time. This amount can be leveraged tax-free with an interest-only, policy loan.
  • Overall, this is somewhat similar to the tax treatment of withdrawals from a Roth IRA with one important difference. Withdrawals from life insurance beyond premiums paid would be subject to taxation, but there are other options for passive income involving life insurance that are usually better than a straight withdrawal.
• Policy loans like the ones mentioned above can be used for any purpose and there are no limits on the types of investments you can make with the funds from a policy loan, giving you more control over your money before retirement. The return on most investments funded through a policy loan is not tax-free, but as long as the return is more than the policy loan interest, this can be a productive way to earn more on the money you save over your lifetime.

At McFie Insurance, we specialize in designing whole life insurance plans to maximize cash value. See what a well-designed whole life insurance policy would do for you and your savings by scheduling a free appointment with us today.

by John T. McFie
I am a licensed life insurance agent, and co-host of the Wealth Talks podcast.
At age 14 I started developing spreadsheet models and software systems to help my Dad share financial concepts with clients. 
Skipped college at 17 recognizing the overinflated value and prices of most college degrees and built more financial software instead (see MoneyTools.net). Still a strong advocate of higher education without going to college.  I enjoy making financial strategies clear and working through the numbers to prove results you can count upon.