As opposed to a traditional 401(k) plan, a Roth IRA is funded by after-tax money, meaning that, although contributions will not be tax-deductible, future withdrawals will be tax-free. A Roth IRA, therefore, may be ideal for someone who estimates that they’ll be placed in a higher tax bracket in retirement compared to their current tax bracket.
Defining the Roth Individual Retirement Account
The difference between a Roth IRA and traditional retirement savings accounts is the way it gets taxed. While contributions to traditional IRAs may come with a tax deduction, you will pay income tax when you withdraw the money in retirement. In contrast, a Roth IRA allows you to withdraw money in retirement without paying taxes (but the contributions are not tax-deductible upfront). Essentially, when deciding between an IRA and a Roth IRA, you’re deciding whether to pay taxes now or later. You’ll have to take a guess whether you’re more likely to be in a higher tax bracket (i.e., have higher income) now versus in retirement.
The Roth IRA’s contribution limit depends on the contributor’s income and is $7,000 per year for incomes that are less than $138,000 per year. The maximum contribution is lower for incomes up to $153,000, while anyone earning more than that is not eligible to make contributions at all.
The most important criteria for a Roth withdrawal to be counted as tax-free are:
The individual contributor’s Roth must be at least five years old.
The account owner must be at least 59 1/2 years old. Exceptions to this rule occur when the person in question has a disability or in situations where the account owner dies.
Roth IRA: How Does It Work?
Another advantage of the Roth IRA is that it’s not as restrictive as other retirement plans. You can add to it even after the age of 70 1/2, assuming you earn an income. There’s also no minimum distribution, unlike other similar plans. You must make all Roth IRA contributions in cash or checks, with payment in the form of assets or securities not being allowed. They can, however, receive their funds from several sources, such as spousal IRA contributions, transfers, rollover contributions, conversions, or normal contributions.
Once the funds are in the Roth IRA, you can invest them in stocks, bonds, various mutual funds, ETFs (exchange-traded funds), money market funds, and CDs. Depending on the IRA provider, you may have a large list of investment possibilities, or a limited one. You should choose your Roth IRA provider depending on your preferences regarding risk and the number of trades you want to engage in. If you want to actively invest your funds, you may want to choose a provider with low trading costs. However, many providers have account inactivity fees, so you must constantly invest.
The most important criteria for a Roth IRA withdrawal to be counted as tax-free are:
The contributor’s age must be over 59 1/2
The Roth IRA account must be at least five years old, with some exceptions, such as first-time home purchases or college-related expenses
The Roth 401(k)
Similar to the Roth IRA, the Roth 401(k) allows you to contribute after-tax money, with post-retirement withdrawals being tax-free. While the Roth 401(k) doesn’t have limits regarding the employee’s income, there are still limits when it comes to the maximum yearly contribution. The maximum yearly deposit amount for 2025 is $23,000. People age 50 and older can contribute $7,500 more for a total of $30,500 per year, allowing them to catch up before retirement.
Differences Between a Roth and a Traditional Retirement Savings Account
The principal differences between a traditional IRA versus a Roth IRA are similar to those between a traditional 401(k) and a Roth 401(k).
Let’s say you earn $3,000 per month. If you make a monthly contribution of 5% to your Roth, $150 will be taken out of your wages after taxes. If you were contributing to a traditional 401(k), the money would be taken out before taxes. Therefore, the most important difference between traditional and Roth accounts is in the way they’re taxed:
Contributions to Roth 401(k) and Roth IRA accounts are taxed when they’re deposited.
Money in traditional IRA and traditional 401(k) accounts are taxed upon withdrawal.
Not all retirement plans sponsored by companies offer a Roth 401(k), and less than half of employees who are given this option choose it instead of a traditional retirement plan.
Before determining if a Roth option is right for you, it’s recommended that you do some research beforehand. You may want to estimate what tax bracket you will be in when you retire and calculate whether the amount of tax you will have to pay justifies choosing a Roth 401(k) over a traditional retirement plan. If you anticipate that, in retirement, you’ll be in a lower tax bracket than the one you are in now, then a traditional 401(k) is a more logical choice.
Benefits of Roth 401(k) and Roth IRA
The Roth 401(k) and Roth IRA are designed for those who are currently in a low tax bracket but anticipate that they will earn more later in life i.e., be in a higher tax bracket in the future. In this case, a Roth option would help that employee by having any contribution taxed at a lower rate, while future withdrawals will be tax-free, even though they’ll be in a higher tax bracket. This makes it attractive for young professionals who estimate that they will have a lot of time to grow their Roth.
Both count as an after-tax investment, meaning that the money going into your retirement plan will be taken out of your paycheck after you pay your taxes. While this means you won’t lower your taxable income as you would with a traditional 401(k), you will reap the benefits when the time comes to withdraw, since your withdrawals will be completely tax-free.
The question of whether you should choose a Roth 401(k) or a traditional 401(k) greatly depends on where you see yourself in the future from a financial standpoint. Similarly, choosing between a Roth IRA and a traditional IRA depends on when and how you want to receive a tax break. However, the first step toward making the right decision is to properly understand your options. If you’re interested in learning more about the 401(k) options out there for you, schedule a consultation to get all the information you need.
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The Human Interest TeamWe believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.
