Roth IRA Vs. Roth 401(k): How They Differ

A Roth 401(k) and a Roth IRA sound similar – and they are.

Contributions are paid after tax, which means that your taxable income is not reduced by the amount of your contributions when you file your income tax return. But you get a huge tax advantage down the road, since earnings can be withdrawn tax-free from age 59.½.

Roth IRA vs. Roth 401(k): How They Compare

The Roth 401(k) has a number of key differences from the Roth IRA. Here’s what to know before deciding which account is right for you.

1. Contribution ceilings

The most distinctive feature of 401(k), whether Roth or traditional, is the high contribution limit, allowing employees to save up to $19,500 per year in 2021. For workers over 50 years, the limit is $26,000.

Meanwhile, annual IRA contribution limits are $6,000, while workers over 50 can contribute up to $7,000 per year.

2. Distributions

An advantage of the Roth IRA is that the account can exist, essentially, forever with no minimum distribution required. There is no obligation to start receiving distributions while the account holder is alive.

In the event of the account holder’s death, a spouse who inherits the Roth IRA will not be required to receive distributions or pay taxes. Anyone other than the spouse listed as the beneficiary must, however, withdraw a minimum amount each year.

A Roth 401(k) has a required minimum distribution starting at age 72, but account holders can roll that into a Roth IRA and avoid the requirement altogether.

3. Employer Matching

In addition to high contribution limits, Roth 401(k)s have another advantage: worker contributions can be matched by the employer up to a certain percentage. This is essentially free money from the employer, in addition to elective deferrals from the employee.

However, if you contribute to a Roth 401(k) account, your employer’s match will be placed in a traditional 401(k) account rather than the Roth account.

“The employer portion never gets to you, so it can’t be done on an after-tax basis,” says Dean Barber, founder and CEO of Barber Financial Group.

For workers who split contributions between a regular 401(k) and a Roth 401(k), the company match will be applied to the traditional 401(k).

4. Investment Options

A Roth IRA allows investors far more control over their accounts than a Roth 401(k). With a Roth IRA, investors can choose from the entire universe of investments, including individual stocks, bonds, and funds. In a 401(k) plan, they are limited to the funds offered by their employer’s plan.

Depending on their plan’s investment menu, employees might be better off maximizing their employer match and then funneling extra retirement dollars into a Roth IRA. This way, they can take advantage of better investment options if the range of funds is too limited in the employer plan.

Also check the fund expense ratios of your Roth 401(k) plan. The lower the expense ratio, the more your investments accumulate over time. Investors paid an average of 0.45% for their mutual funds and exchange-traded funds in 2019, according to the most recent data from Morningstar Research Services. If your 401(k) plan funds are greater than 1% and you have reached the maximum of any employer correspondencestrongly consider investing in a Roth IRA.

5. Income Limits

There are income limits for Roth IRA contributions. If your adjusted adjusted gross income in 2021 is $208,000 or more for married couples filing jointly or $140,000 or more for single filers, accounts are prohibited. However, you still have the option of getting a Roth IRA backdoor — legally.

There is no income limit on Roth 401(k)s.

6. Rules for early withdrawals

Withdrawals from Roth 401(k)s and Roth IRAs are tax-exempt if they meet certain criteria:

  • Accounts must be kept for at least five years.
  • Account holder turns 59½or distributions are made in the event of disability or death.

With a Roth IRA, you can always withdraw the money you’ve contributed without tax implications. But with a Roth 401(k), if you want to withdraw money sooner, you may have to pay a 10% penalty tax on the earnings withdrawn, but not on the amounts you contributed. Otherwise, to access your 401(k) funds tax-free, you will usually need to take out a Roth 401(k) loan, if the plan allows it.

With a Roth IRA, you can withdraw up to $10,000 to buy, build, or rebuild a first home and avoid paying taxes and the 10% early withdrawal penalty even if you’re under 59.½. You can also withdraw money for eligible educational expenses while avoiding taxes and penalties.

You can have a Roth IRA and a Roth 401(k)

It is possible to have both a Roth IRA and a Roth 401(k) at the same time. However, keep in mind that a Roth 401(k) must be offered by your employer in order to participate. Meanwhile, anyone with earned income (or any spouse whose partner has earned income) can open an IRA, given the stated income limits.

If you don’t have enough money to maximize contributions to both accounts, experts recommend maximizing the Roth 401(k) first to get a full employer match.

Roth IRA or Roth 401(k): which is better?

Determining which account will best suit your needs depends on your current and future financial situation, as well as your own specific goals.

High earners who want to contribute annually to retirement accounts should consider a Roth 401(k) because they don’t have an income cap. Additionally, people who want to make large contributions can put more than three times the amount in a Roth 401(k) as in a Roth IRA.

Those who want more flexibility with their funds, including no required distributions, could consider a Roth IRA. This would be particularly useful if you wish to leave the account to an heir. But Roth 401(k) accounts can be transferred into a Roth IRA later in life anyway.

At the end of the line

Both the Roth 401(k) and the Roth IRA are great tools to help you save for retirement. As long as you can avoid making early withdrawals, you’ll be able to withdraw money tax-free in retirement and beyond. Make sure you understand the slight differences between the two options so you can determine the right savings balance for your financial situation.

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Sarah J. Greer