Navigating your retirement plan can be confusing. The Roth 401(k) and the Roth IRA are two common and popular retirement vehicles. But which one is right for you?
Roth IRAs
A Roth IRA is an individual retirement account that lets you set aside after-tax income up to a specified amount each year. The money you contribute to a Roth IRA comes from earned income that you’ve already paid taxes on.
Unlike with a traditional IRA, you don’t get an upfront tax break. But the key benefit of a Roth IRA is that your contributions and the earnings on those contributions grow tax-free and can be withdrawn tax-free in retirement.
Just as with a traditional IRA, there are limits to how much you can contribute to a Roth IRA per year. Unlike the Roth 401(k), which has no income limits, Roth IRAs have an upper limit for how much you can earn in a year and still make eligible contributions.
For 2024:
- Maximum Contribution: $7,000 for individuals under age 50, an increase from $6,500 in 2023.
- Catch-Up Contribution: $1,000 for individuals aged 50 and older. So for those 50 and older can contribute a total of $8,000.
Roth 401(k)s
The availability of Roth 401(k) plans among employers has been increasing. As of 2021, about 88% of 401(k) plans offer a Roth 401(k) option in addition to the traditional 401(k) option.
A Roth 401(k) is an employer-sponsored retirement savings account that is funded with after-tax dollars. This means that income tax is paid immediately on the earnings that you deduct from each paycheck and deposit into the account. This type of plan is different from a traditional 401(k) plan, which is funded with pre-tax money.
Your money grows tax-free, and you don’t have to pay taxes when you make qualified withdrawals upon retirement.
- Maximum Employee Contribution: $23,000, up from $22,500 in 2023.
- Catch-Up Contribution: $7,500 for those aged 50 and older. So for those 50 and older can contribute a total of $30,500.
Employer Matching
If your employer offers a 401(k) matching program, they will match your contributions to your Roth 401(k) up to a specific limit.
Though you contribute to your Roth 401(k) with after-tax dollars, employer-matching contributions are made with pre-tax dollars. Also, employer-matching grants can only be made to a regular 401(k) plan.
This means that while your contributions to a Roth 401(k) can be withdrawn tax-free in retirement, any employer-matching contributions and their earnings are placed in a separate, regular 401(k) account, which will be subject to income tax upon withdrawal.
Withdrawal Rules
Money in a Roth 401(k) and Roth IRA account grows tax-free and can be withdrawn tax-free in retirement. The rules for withdrawing from a Roth account are as follows:
- You can begin withdrawing funds from your Roth without penalty once you reach age 59 1⁄2
- If you withdraw funds before age 59 1⁄2, you may be subjected to early withdrawal penalties, though certain exceptions are permitted, such as if you become permanently disabled.
- Qualified withdrawals, which are not subject to tax or penalty, are those that occur after you reach 59 1⁄2 and have held the Roth account for at least five years.
- Non-qualified withdrawals from a Roth are subject to income tax and a 10% penalty on the earnings portion of the withdrawal.
With both Roth IRA and Roth 401(k) accounts, you’re making after-tax contributions. Since the money contributed has already been subject to income tax, your withdrawals during retirement (including the earnings on your contributions) are tax-free, as long as you’ve reached the age 59 1⁄2 and the account has been open for at least five years.
Required Minimum Distributions (RMD)
Most retirement accounts are subject to Required Minimum Distributions (RMD). RMD rules require individuals to start taking money from tax-deferred accounts like 401(k)s and IRAs starting at age 72.
Roth 401(k) accounts are subject to the Required Minimum Distributions (RMD) rules, but only for 2022 and 2023. From 2024 onwards, the RMD rules will no longer apply to designated Roth 401(k) accounts.
But keep in mind that for 2023, RMDs must still be taken from these accounts, including those with a required beginning date of April 1, 2024. And even though there is a minimum amount you must withdraw, you are always permitted to draw more than this minimum if you choose to.
Unlike Roth 401(k) accounts, Roth IRAs are not subject to Required Minimum Distributions (RMD) rules. If the Roth 401(k) account Required Minimum Distributions apply to you, rolling over assets from a Roth 401(k) to a Roth IRA can be a way to avoid taking RMDs.
If you roll over your Roth 401(k) money into a Roth IRA, you can effectively avoid taking RMDs during your lifetime. This strategy gives you more control over when and how much you withdraw from your retirement savings. However, the Roth IRA five-year rule applies, which means you may have to wait five years to pull your money out of the Roth IRA without penalty.
Investment Options
Roth IRAs offer the flexibility of self-directed investing, which opens up a wide range of investment possibilities. This includes individual stocks, bonds, mutual funds, and exchange-traded funds (ETFs), providing you with diverse assets to choose from.
In comparison, Roth 401(k) accounts typically offer a preselected menu of investment options, such as various types of mutual funds or ETFs, where your contributions are invested in those you choose at specific amounts you set.
If you want more control over your investments and access to a broader selection of assets, contributing to a Roth IRA account can provide that flexibility.
Which is Right for You?
Both a Roth 401(k) and a Roth IRA provide substantial tax benefits. If your employer provides a Roth 401(k) option and you’re also eligible to make contributions to a Roth IRA, there are some factors you’ll want to take into account.
If you’re early in your career and expect your income (and therefore tax rate) to increase over time, both a Roth 401(k) and a Roth IRA could be beneficial over a regular 401(k) or traditional IRA. With these Roth accounts, you pay taxes now when your income is lower.
The Bottom Line
One of the main advantages of a Roth 401(k) is the much higher contribution limit. In addition, many employers offer matching contributions, effectively giving you “free money” towards your retirement.
However not all employers offer a Roth 401(k) account option, and unlike a Roth IRA, a Roth 401(k) requires you to take required minimum distributions (RMDs) starting at age 73 (though for 2024 and later years, RMDs are no longer required).
A Roth IRA is an individual retirement account you open and fund yourself. Compared to the Roth 401(k), the Roth IRA offers more flexibility with investment options and its withdrawal rules. The downside for some is that they have an upper limit for how much you can earn in a year and still make eligible contributions.
For example, Roth IRAs allow you to withdraw your contributions at any time or at any age without incurring tax or penalty. Withdrawals on earnings, however, could be subject to income taxes and a 10% penalty, depending on your age and how long you’ve had the account. And unlike a Roth 401(k), there are no RMDs for a Roth IRA during your lifetime.
If your employer offers a match on your Roth 401(k) contributions, it’s a no-brainer to contribute at least enough to get the full employer match before contributing to a Roth IRA.
Also, contributing to both a Roth 401(k) and a Roth IRA can make sense if you’re eligible to contribute to both types of accounts and your goal is to maximize the amount of money to put away in retirement each year.
Overall, the choice between a Roth 401(k) and a Roth IRA is personal and will come down to your goals, your income, contribution limits, and investment flexibility. If you feel overwhelmed, consult with a Certified Financial Planner to help you analyze your circumstances and craft a plan that’s right for you.
