Roth individual retirement arrangements and 401(k) plans both offer tax benefits for people saving for retirement. In some ways, the two plans are polar opposites. For example, contributions to a 401(k) aren't taxed but distributions are, and Roth IRA contributions are taxed but distributions aren't. Still, the plans have several similarities.
Once you get the money in your 401(k) plan or Roth IRA, it grows tax-free as long as it remains in the account. That means none of the income it earns each year goes to paying taxes. As a result, the money grows faster than if you were having to use some of the earnings to pay taxes each year.
If you don't have compensation, you're not allowed to contribute to either type of plan. A 401(k) plan is funded only with money paid to you by the company offering the plan. For example, if you work multiple jobs and have $12,000 of salary from the company with the 401(k) plan, you can only contribute $12,000. Any earned income as well as taxable alimony may be used to fund a Roth IRA.
Both 401(k)s and Roth IRAs limit how much money you can contribute to each plan on an annual basis. The IRS updates each limit annually. For example, in 2013, you can contribute up to $5,500 to your Roth IRA ($6,500 if you're 50 or older) and $17,500 ($23,000 if you're 50 or older) to your 401(k) plan.
Your 401(k) plan can also accept contributions from your employer on your behalf, while Roth IRAs are limited to individual contributions.
Early Withdrawal Penalties
Any time you take a taxable early withdrawal from either plan, you must pay an extra 10 percent penalty on top of the income taxes. What qualifies as an early distribution varies. For a 401(k) plan, if you're not 59 1/2, it's an early withdrawal and the whole thing is taxable. For a Roth IRA, if the account isn't 5 years old, or you aren't 59 1/2, permanently disabled or taking out up to $10,000 for a first home, it's not qualified. However, you get all your contributions out tax-free first, so only the earnings you take out after exhausting your contributions are taxable.
There is overlap between the exceptions from the early withdrawal penalty for a Roth IRA and a 401(k). Suffering a permanent disability, receiving payments as a beneficiary from an inherited account and significant medical expenses will get you out of the penalty from either account. In addition to the common exceptions, early withdrawals for higher education expenses and first-time home purchases are exempt for Roth IRA owners, while a 401(k) lets you avoid the penalty if you leave your job after turning 55.
- Internal Revenue Service: Publication 590 -- Individual Retirement Arrangements (IRAs)
- Internal Revenue Service: General Distribution Rules
- Internal Revenue Service: Limitation on Elective Deferrals
- Internal Revenue Service: IRS Announces 2013 Pension Plan Limitations
- Internal Revenue Service: Topic 424 - 401(k) Plans
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."