Saving for retirement is one of the biggest financial goals for most of us, and sometimes, figuring out which type of accounts to use can be a really confusing problem. Depending on who you are and what kind of work you do, you have a number of options: traditional IRA, Roth IRA, 401(k), Roth 401(k), solo 401(k), SEP IRA, SIMPLE IRA and quite a few more. The list of accounts can be overwhelming, so learning the basics, piece by piece, makes it a lot more manageable. In this article we’re going to look at two of the options: Roth IRA vs Roth 401(k). These two types of retirement accounts are broadly similar, but have lots of important differences.
ROTH IRA AND ROTH 401(K) – SIMILARITIES
CONTRIBUTIONS ARE NOT TAX DEDUCTIBLE
The Roth IRA and Roth 401(k) are both funded with “after tax dollars”. This means you can not deduct your contributions from your taxable income. If your income is $50,000 and you contribute $5,000 to a Roth account, you are still taxed on $50,000 of income.
This differentiates Roth accounts from non-Roth accounts, like a traditional IRA or traditional 401(k). With non-Roth accounts like these, your contributions are made with “pre-tax dollars”. This means that you can deduct your contributions from your income for tax purposes. If your income is $50,000 and you contribute $5,000 to a non-Roth IRA or 401(k), you are only taxed on $45,000 of income.
So in other words, you don’t get any up-front tax savings from your Roth contributions. The tax savings in a Roth account come when you take your money out, as we’ll see next.
DISTRIBUTIONS ARE TAX-FREE
Since there is no tax deduction in the year you contribute to a Roth account, all qualified distributions from the account in retirement are completely tax-free. So when you take money out of a Roth account in retirement, you don’t have to pay tax on any of that money.
THE DIFFERENCES
CONTRIBUTION LIMITS
One of the most significant differences between a Roth IRA and a Roth 401(k) is the contribution limit. A Roth 401(k) has a much higher contribution limit than a Roth IRA.
Roth IRA: In 2019, the contribution limit for a Roth IRA is $6,000. The limit is $7,000 if you are 50 years of age or older.
Roth 401(k): On the other hand, the contribution limit for a Roth 401(k) is $19,000. The limit is $25,000 if you are 50 years of age or older.
INCOME LIMITS
Roth IRA: In order to contribute to a Roth IRA, your modified adjusted gross income must be below $203,000 if married filing jointly, or $137,000 for single filers.
Roth 401(k): There are no income limits to qualify for Roth 401(k) contributions. Anyone with access to a Roth 401(k) can contribute, regardless of their income.
REQUIRED MINIMUM DISTRIBUTIONS
A required minimum distribution (RMD), is a distribution from a retirement account that you must take once you reach the age of 70½, or when you retire, whichever is later. The amount of the RMD is calculated based on the balance in your retirement account and your age.
Roth IRA: you do not have to take RMDs from a Roth IRA. In fact, you are not required to take any distributions from a Roth IRA during your lifetime if you don’t want to. This is one of the qualities that makes a Roth IRA a great vehicle for passing money on to heirs.
Roth 401(k): You are required to take RMDs from a Roth 401(k).
- Note: You can avoid RMDs on funds in a Roth 401(k) by rolling over the Roth 401(k) into a Roth IRA before the year in which you turn 70½.
EMPLOYER MATCHING
Roth IRA: Employer matching does not apply. Since an IRA is an individual account and is not administered by your employer, there is no opportunity for employer matching.
Roth 401(k): Many employers will offer to match your 401(k) contributions up to a set percentage of your income. This is free money and should always be taken advantage of. If you contribute to a Roth 401(k) and get an employer match, the employer contributions will go into a traditional 401(k), not your Roth 401(k) (you’ll have both types of 401(k) accounts). Employer contributions are made with pre-tax dollars, so they can’t go into a Roth account.
INVESTMENT OPTIONS
Roth IRA: One big advantage of an IRA is that you can hold virtually any type of investment in the account. In an IRA, you can have your choice of mutual funds, ETFs, individual stocks and bonds, commodities, real-estate, cash, and basically any other investment you can think of.
Roth 401(k): Your investment options are much more limited in a 401(k). You can only put your money into the investments chosen by your retirement plan administrator. If you are a savvy investor, and want to primarily invest in low cost index funds, your 401(k) plan may or may not offer the investment options you want. 401(k) plans have a bad reputation of offering lots of high cost investment options that are not ideal for most investors.
FEES
Roth IRA: There are no fees associated with having a Roth IRA account. However, the investments held within the Roth IRA may have fees associated with them. An example is the expense ratio of a mutual fund held within a Roth IRA. Although the Roth IRA itself has no fee, you must still pay the expense ratios of the investments within the account.
Roth 401(k): There are fees charged by the plan administrator for running the 401(k) plan. Depending on your specific 401(k) plan, these fees will be paid either by you, or by your employer. On top of the administrative fees, you still must pay any fees associated with the investments within the 401(k) account (like mutual fund expense ratios) just as you would in any investment account.
Make sure you check your statements and fee disclosures so you know how much you are paying for your 401(k) plan. Sometimes the fees are well hidden, so when in doubt, contact your human resources department and ask.
ACCESS TO MONEY BEFORE RETIREMENT
Roth IRA: You are free to withdraw your contributions to a Roth IRA at any time, with no taxes or penalties. If you withdraw your earnings, they will be subject to income tax and a 10% penalty (unless an irs exception applies) .
Roth 401(k): If your Roth 401(k) account consists of both contributions and earnings, you will not be able to withdraw tax and penalty-free money from the account. You will at least have to pay income tax on the earnings portion of the distribution, and also a 10% penalty if you don’t meet one of the IRS exceptions.
Many 401(k) plans allow you to take a loan from your Roth 401(k) in the amount of 50% of the account balance up to $50,000. But this loan must be repaid within 5 years in generally equal payments made at least quarterly.
ACCESS TO ACCOUNTS
Roth IRA: As long as the income requirements are met, you can open and contribute to a Roth IRA if you have earned income. Access to Roth IRA accounts is not dependent on your employer.
Roth 401(k): You will only have access to a Roth 401(k) account if it is an option offered by your employer. The availability of Roth 401(k) accounts is becoming more common, but still not all employers offer them.
CAN YOU HAVE A ROTH IRA AND A ROTH 401(K)?
Yes. If you meet the income requirements to contribute to a Roth IRA and your employer offers a Roth 401(k), you can open both types of accounts.
IF YOU HAVE ACCESS TO BOTH ACCOUNTS
If you have access to both types of accounts, here are some steps to go through to determine where you should put your money first to minimize your fees and maximize your investment options:
- Always contribute enough to your 401(k) to take full advantage of the employer match. The employer match is free money, take it! Having your employer match your contributions is a guaranteed excellent return on your investment.
- Evaluate the investment fees and investment options in your Roth 401(k). Make sure the fees are acceptable and that the types of investments you want are available to you.
- If the 401(k) fees are high or your investment options are not ideal, consider just maxing out the employer match in your Roth 401(k) to start. Then open a Roth IRA and contribute as much as possible into whatever investments you want. If you have more to invest after maxing out the Roth IRA, you can go back to contributing the remainder to your 401(k) (or you can invest in a regular taxable investment account if your 401(k) investment options are really terrible).
WHICH ACCOUNT SHOULD YOU USE: GENERAL GUIDELINES
- Roth 401k – Usually better for higher income earners who want to make roth retirement contributions. This is because of the higher contribution limit and the lack of an income restriction for contributions.
- Roth IRA – Usually better for someone who wants more flexibility regarding investment options and distributions. If you want to leave the account to heirs and not take RMDs, a Roth IRA is a great account to consider.
