When it comes to the Roth IRA vs. the Roth 401(k), there are many similarities to keep in mind. For example, both plans let investors build up tax-free income for retirement, yet both fail to offer any upfront tax benefits in the year you contribute.
That said, there’s one major difference between the Roth IRA and the Roth 401(k). One of these plans is an employer-sponsored plan, and the other is a self-directed account that you can open on your own if you’re eligible.
With that in mind, it’s not surprising that the IRS allows certain specific benefits for each plan type. Read on to learn about the advantages of each of these accounts and other details to consider when you’re looking at the Roth IRA versus the Roth 401(k).
Roth IRA vs. Roth 401(k) — The Similarities
On the surface, the two Roth plan types seem to be identical. Here are some of the main similarities you should know about before you consider opening one or both of these accounts.
Both Provide Tax-free Distributions in Retirement
The biggest distinguishing factor about these two Roth plans is the fact they create the opportunity to build up a tax-free income source in retirement. This benefit is available whether you have a Roth IRA or a Roth 401(k) plan.
To qualify for tax-free income in retirement, distributions that include earnings cannot be taken before you reach age 59 ½. In addition, you must be participating in a Roth plan for a minimum of five years at the time distributions are taken. But, as long as you meet those two criteria, the distributions you receive from the plan will be tax-free.
This makes Roth plans completely different from other tax-sheltered retirement plans, such as traditional IRAs and regular 401(k) plans. All other retirement plans are merely tax-deferred. That means that, while you get generous tax benefits during the accumulation phase of the plan with a 401(k), you will have to pay ordinary income tax when you begin taking distributions in retirement.
In this way, both Roth IRAs and Roth 401(k) plans provide excellent tax diversification strategies for retirement. This means either will allow you to have at least some tax-free income along with other income sources that are fully taxable.
Neither offers Tax-deductible Contributions
When you make a contribution to a Roth plan, whether it’s a Roth IRA or a Roth 401(k) account, there is no tax deduction upfront. This is unlike both traditional IRAs and 401(k) plans, where contributions are generally fully deductible in the year they’re made.
In fact, tax deductibility of contributions is one of the major reasons why people participate in retirement plans. If you use a plan that does let you deduct your contributions upfront (i.e. a traditional 401k retirement plan), you get to lower your taxable income in the year you contribute.
You can Withdraw Your Contributions from Either Plan at Any Time — Tax-free
Another unique feature of both Roth accounts is the fact you can withdraw your contributions at any time without having to pay either ordinary income tax or the 10% early withdrawal penalty on the distributions. This is in part because Roth IRA contributions are not tax-deductible at the time they are made. But it’s also true because of IRS ordering rules for distributions that are unique to Roth plans. Those ordering rules enable you to take distributions of contributions ahead of accumulated investment earnings.
There is some difference in exactly how early distributions are handled among Roth IRAs and Roth 401(k)s.
Early distributions from Roth IRAs enable you to first withdraw your contributions — which were not tax-deductible — and then your accumulated investment earnings once all of the contributions have been withdrawn. This provides owners of Roth IRAs with the unique ability to access their money early, without incurring tax consequences.
With Roth 401(k)s, on the other hand, the contribution portion of your plan can also be withdrawn free of both ordinary income tax and early withdrawal penalties. But since they’re 401(k)s, they’re also subject to pro-rata distribution rules.
If you have a Roth 401(k) with $20,000 invested ($14,000 in contributions and $6,000 in investment earnings) then 30% ($6,000 divided by $20,000) of any early distribution that you take will be considered as investment income.
If you take a $10,000 early distribution, $3,000 of it, or 30%, will be considered investment income and subject to both income tax and the 10% early withdrawal penalty. The remaining $7,000, or 70%, will be considered a withdrawal of contributions, and therefore not subject to tax or penalty.
IMPORTANT NOTE: Not all 401(k) plans permit early withdrawal of Roth contributions, for all the same reasons they don’t permit early withdrawals from 401(k) plans in general.
Many only allow for early withdrawals as either loans or hardship withdrawals. The rules we discussed above are IRS rules, not employer rules.
Both offer Tax-deferred Investment Returns
Despite the lack of contribution deductibility, both plans have one major feature in common with other retirement plans. With both the Roth IRA and the Roth 401(k), money contributed to the plans will accumulate investment income on a tax-deferred basis.
So, how can an account that is supposedly tax-free in retirement, be merely tax-deferred during the accumulation phase?
It comes down to early withdrawals. We’ve already discussed how you can withdraw your contributions early from either a Roth IRA or Roth 401(k) without creating a tax liability. But if your distributions also include investment earnings, the situation is different.
Accumulated Investment Earnings are Taxable if Withdrawn Early
Whether you have a Roth IRA or a Roth 401(k), if you take distributions from either plan that includes investment earnings (which it will under the pro-rata rules for the Roth 401(k)), and you are either under age 59 ½, or have been participating in the Roth plan for less than five years), those earnings will create a tax liability.
Let’s say you have been taking early distributions from your Roth plan. You have already withdrawn the full amount of your contributions to the plan. You continue taking distributions, but you are now withdrawing funds that represent accumulated investment earnings.
Those withdrawals — the ones that are composed of accumulated investment earnings — will be subject not only to ordinary income tax, but also the 10% early withdrawal penalty. In this way, early distributions from a Roth plan are handled the same way they are for other retirement plans, at least in regard to the withdrawal of investment earnings.
Distributions from Either won’t Affect the Taxability of Your Social Security Benefits
This is another advantage that applies to both the Roth IRA and the Roth 401(k) plan.
Distributions from other retirement plans are added to your taxable income in retirement. Not only will those distributions be subject to income tax, but they will also affect your income in calculating how much of your Social Security income will be subject to income tax.
Under current law, Social Security income is subject to income tax using a two-tiered calculation. If your combined retirement income falls below one of these limits, then your Social Security benefits are not taxable. However, if you are single and your combined income exceeds $25,000, then 50% of your Social Security benefit will be taxable.
If you’re married filing jointly and your combined income exceeds $44,000, then 85% of your Social Security benefit will be taxable.
Note that the term “combined income” refers to income from all other sources — investment income like interest, dividends and capital gains; other retirement income, like pensions and distributions from traditional IRAs and 401(k)s; and any earned income.
Amazingly, your Roth plan distributions don’t count toward that calculation! For Social Security purposes, it’s as if the distributions from your Roth plans don’t exist. Since they’re not taxable, they’re not included in “combined income” and will be excluded from the threshold calculations.
This is yet another way Roth plans provide for tax diversification in retirement.
Your Roth plan distributions don’t count toward that calculation! For Social Security purposes, it’s as if the distributions from your Roth plans don’t exist.
Since they’re not taxable, they’re not included in “combined income”, and will be excluded from the threshold calculations.
That covers the similarities between Roth IRAs and Roth 401(k)s. But let’s move on to the differences.
Differences Between Roth IRA and Roth 401(k)
Most of the differences between the Roth IRA and Roth 401(k) have to do with the fact the Roth 401(k) is offered as an employer-sponsored plan. That by itself creates a lot of differences, including the following.
Contribution Amounts
The maximum you can contribute to a Roth IRA in 2023 is $6,500, or $7,500 if you’re age 50 or older. This is an increase from previous years.
That said, Roth 401(k) contributions are potentially more than three times higher!
The employee contribution limit for 2023 for a Roth 401(k) plan is $22,500 per year, or $30,000 if you are age 50 or older (up from $20,500 and $27,000 for 2022). If you participate in a 401(k) plan that also has a Roth 401(k) provision, you could actually contribute up to the maximum 401(k) contribution limit entirely to your Roth 401(k).
Now, that doesn’t mean you want to contribute the entire amount to the Roth portion. After all, the Roth 401(k), being a Roth plan, does not offer tax-deductible contributions. Depending on your age, $22,500 or $30,000 may be a lot of money to take out of your paycheck without getting a tax break. But, it still gives you a lot more room to allocate funds to a Roth plan than what you can with a Roth IRA account.
Employer Matching Contributions
As an employer-sponsored retirement plan, you can also get an employer matching contribution in a Roth 401(k) plan. Since the Roth IRA is a self-directed account, the employer match does not exist.
Though not all employers offer either the Roth 401(k) or even an employer matching contribution, the ones that do may not make a distinction between a regular 401(k) and the Roth portion. In that situation, if the employer offers a 50% match on your contribution, that means there will be a 50% match on the part of your contribution that goes into your Roth 401(k).
There is one limitation on the employer match, however. Since a Roth 401(k) is a fully segregated account in your retirement plan, the employer cannot put matching contributions into that part of your plan. Instead, the employer match goes into your regular 401(k) plan.
That means that, even if you were to allocate 100% of your 401(k) contribution into the Roth portion, you would still have a regular 401(k) if the employer offers a match.
That means even if you were to allocate 100% of your 401(k) contribution into the Roth portion, you would still have a regular 401(k) if the employer offers a match.
While it would be an advantage to have the employer match going into the Roth 401(k) as well, that would create a tax problem. Since the employer match is not taxable to you when made, it would be taxable when you begin taking distributions from the plan. For this reason, you’re better off having it in the regular 401(k) portion of your plan, where it will be tax-deferred.
Loan Provisions
Since a Roth 401(k) is part of an employer-sponsored plan, a loan provision may be available on it.
Not all employers offer loan provisions on their 401(k) plans. But if they do, the IRS permits you to borrow up to 50% of the vested balance of your account, up to a maximum of $50,000. Naturally, if you do take the loan against your plan, you will have to make monthly payments, including interest, until the loan is repaid.
Once again, since a Roth IRA is a self-directed plan, no loan provision is available.
Required Minimum Distributions (RMDs)
This is where the Roth IRA and a Roth 401(k) are completely different. IRS required minimum distribution (RMD) rules require that you begin taking mandatory distributions from your tax-sheltered retirement plan beginning at age 72. However, if the Secure Act 2.0 were to pass both houses of Congress and become law, the age you are required to begin taking RMDs could increase to 75 over the next decade,
Whatever age you wind up having to take RMDs, withdrawals are based on a percentage calculated based on your remaining life expectancy at the age that each distribution is made.
Either way, the difference between these two accounts is obvious here. Roth 401(k) plans are subject to RMD provisions, whereas Roth IRA accounts are not.
The benefit of not being required to take RMDs is you can allow your Roth IRA to grow for the rest of your life. This will enable you to leave a larger amount of money to your heirs upon your death.
**A Roth IRA is an excellent strategy to avoid outliving your money. Since RMD’s are not required, the money in a Roth IRA can be available for the later years of retirement, when other plans may have been severely drawn down.
Income Limits
There are no income limits restricting your ability to make Roth 401(k) contributions. As long as you’re participating in the 401(k) plan, you’re able to make contributions to a Roth 401(k).
However, this is not true with a Roth IRA at all. If your income exceeds certain limits, you will not be able to make a contribution to this type of account directly.
For 2023, the Roth IRA income limits look like this:
- Married filing jointly, or qualifying widow(er) — allowed up to an income of $218,000, partial contributions allowed between $218,000 and $228,000, after which no contribution is allowed.
- Married filing separately — partial contribution on an income up to $10,000, after which no contribution is allowed.
- Single, head of household, or married filing separately AND you did not live with your spouse at any time during the year — allowed up to an income of $138,000, partial contributions allowed between $138,000 and $153,000, after which no contribution is allowed.
Trustee and Investment Selection
This is another area that usually favors Roth IRA plans. As a self-directed account, a Roth IRA can be held with the trustee of your choosing. That means you can decide on an investment platform for the account that meets your requirements for both fees and investment selection.
You can choose a platform that charges low fees, as well as one that offers the widest variety of potential investments. You can even open your Roth IRA with one of the best online brokerage firms.
But with a Roth 401(k), since it’s part of an employer-sponsored plan, you will likely have no choice in the matter. This is one of the biggest issues people have with employer-sponsored plans. The trustee selected by the employer may charge higher than normal fees.
They also commonly restrict your investment options. For example, while you might choose a trustee for a Roth IRA that has virtually unlimited investment options, the trustee for a Roth 401(k) may limit you to no more than a half a dozen investment choices.
Roth IRA vs Roth 401k: Which Will Work Better for You?
Fortunately, most people won’t have to make a choice between a Roth IRA and a Roth 401(k). That’s because current law allows you to have both. That is, you can have a 401(k) plan with a Roth 401(k) provision and still fund a Roth IRA. You can do that as long as your income does not exceed the limits required for making a Roth IRA contribution.
There’s also a maximum combined limit for contributions to all retirement plans. For 2023, it’s $66,000, or $73,500 if you’re 50 or older. The Roth 401(k), because it is part of a 401(k) plan in general, provides much higher contribution limits. This will enable you to save a very large amount of money. As well, you always have the choice to allocate some of your 401(k) contribution into a regular 401(k). That means that the portion contributed to the traditional 401(k) will be tax-deductible.
Still, the big advantage to also having the Roth IRA is the fact you can access many more investment options. That means you can make the best of the investment selections offered within your 401(k) plan, but still expand your investing activities through your Roth IRA based on your goals.
Finally, don’t forget that having a Roth IRA means you will already have an account in place if you leave your employer and need an account to transfer your Roth 401(k) into. In addition, you could also do a Roth IRA conversion of the balance that’s in your traditional 401(k) plan.
At the end of the day, all of this means that you should take advantage of both the Roth IRA and the Roth 401(k) plan if you have the option to do both.
This article originally appeared on Good Financial Cents and was syndicated by MediaFeed.
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Saving for retirement is one of the most important financial goals there is, but it isn’t always easy. Even with the best intentions, it can be difficult to discipline yourself to put money away for a nebulous “someday,” especially when you’re busy trying to make ends meet now.
But there are plenty of ways to save for retirement more efficiently, making every dollar go a little bit further toward a well-deserved rest in your golden years.
A lot of the “getting started” part is becoming educated on how different retirement plans work and what your options might be depending on your financial situation.
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If your company offers a 401(k), it’s usually a good idea to contribute to it at least a little bit. The contributions will be automatically deducted from your paycheck and may also be made from pre-tax money, which will lower your taxable income.
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If your employer offers a 401(k) match, there is even more incentive to contribute. A match is about as close as it comes to free money and is considered part of an employee benefits package. Your company may have a vesting schedule, meaning you don’t obtain full ownership of its contributions until you’ve been working at the company for a certain amount of time. You’ll always maintain full ownership over the money your contributions, however.
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Thanks to the power of compound interest, the earlier you start saving for retirement, the more you’ll likely make over time. It’s never too early to start, so get cracking!
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Making regular contributions is one of the best ways to grow your retirement funds. With a company-sponsored retirement fund like a 401(k), the money comes out of your paycheck each period. But if you’re DIYing your retirement with an IRA, for instance, you’re in charge of making sure money’s going in.
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Even if you are actively investing in a 401(k), you may be able to boost your retirement savings even more by also opening an IRA. If you’re self-employed or working at a job that doesn’t offer retirement benefits, an IRA might be the very best choice available for you. IRAs are easy to open and available to almost anyone, so long as you earn an income.
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The contribution maximum for IRAs is relatively low, compared to 401(k). For 2022, you can contribute up to $6,000 per year to your IRA, or $7,000 if you’re aged 50 or over and eligible for catch-up contributions. Maxing out your IRA each year can help set the foundation for a successful retirement and also help you save money on taxes during the year the funds are contributed if you’re eligible.
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A Roth IRA works a little differently than traditional IRAs and 401(k)s. Rather than getting a tax break now, you’ll get it later when you take the funds out during your retirement years. If you’re eligible for a Roth account, you may be able to have some tax-free income in retirement.
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If you earn more than $129,000 as a single person or $204,000 as a couple (for 2022), your eligibility to contribute to a Roth is reduced, and if you earn much more than that, you may be ineligible entirely. However, you can still transfer the funds in a traditional IRA into a Roth account, provided you pay income taxes when you do so. This can help you score those tax-free earnings, even if you earn too much to directly contribute.
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Contributing to your 401(k), or any retirement account, is just the start. In order to get that money growing, you need to make sure it’s allocated into investment categories like stocks, bonds, and cash. How your investments are allocated is likely to change over time, depending on your risk tolerance and the length of time before you plan to retire.
(If you have specific investment questions, we always recommend chatting with a qualified financial planner or other investing professional.)
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Allocation and diversification go together like peanut butter and jelly. Maintaining a diverse portfolio helps you avoid having all of your investment eggs in one basket. If one company (or even one segment of the market) starts to falter, you have other investments to fall back on.
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Even if you’re diligent in looking at how to maximize your retirement savings, maintenance and trading fees can quickly eat into your funds. These fees do vary depending on what financial institution manages your account. It’s worth shopping around for an account that has reasonable 401(k) fees.
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An HSA, or Health Savings Account, isn’t a retirement vehicle in its own right, but it can help you boost your retirement savings if it is treated as a retirement account. To qualify for an HSA, you must have a High Deductible Health Plan, among other requirements. HSAs are portable, so you can take them with you if you change employers or retire. Distributions taken for qualified medical expenses are tax-free, but non-medical distributions are taxable and may be subject to an additional 20% penalty.
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These days, few people stay at the same job for their whole careers. If you’ve been accruing retirement savings in a 401(k), it could be tempting to cash it out and treat it as a windfall when you change employers. But early withdrawal comes with a 10% penalty tax from the IRS, not to mention the regular income taxes you’ll have to pay on the money. It’s probably a way better idea to roll it into a new 401(k) or IRA and keep it growing.
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After you’ve taken the steps to start saving for retirement and have a solid plan in place, it’s a good idea to make sure you are contributing as much as you can during your prime working years.
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This one might cause a little stress, but it can pay off with an income increase just with a single conversation. Gather the specifics about why you’re an awesome employee and put on your negotiating hat. If you’re feeling bold, you might also ask for a retirement-specific benefit as part of the deliberations, like an increased 401(k) match!
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Budgeting is the key to so many personal finance matters, and saving for retirement is no different. By seeing where the money is coming in and going out, you might find some places to cut back and find more money to stash away for the future. If you haven’t spent some time with your budget in a while, sit down and get to know it.
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The amount you’re able to set aside for retirement will depend on your current earnings, cost of living, and many other factors. While an oft-cited rule of thumb suggests saving 15% of your income, that may not be feasible for you.
However, it’s still worthwhile to sit down and set a specific monthly retirement savings goal and commit to putting that much away. Focusing on how to increase your savings rate when your income or other life factors change will likely keep your retirement goals in sight.
Related: How to Make a Monthly Budget
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When you’re budgeting your income and expenses, it can be easy to leave savings as the last line item. By committing to saving first (setting money aside as soon as you get it), you’ll ensure you’re actually contributing to your retirement fund on a regular basis, helping it continue to grow as effectively as possible over time.
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One easy way to ensure you don’t fall behind: Automate your retirement savings. Most brokerages and platforms have an option to allow you to automatically invest a certain amount on a regular basis. Again, just be sure you’re actually allocating the funds once they hit your account.
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We’ve all got to eat, which means we all spend money on food. But how much money we spend is another matter entirely. According to the latest data from the USDA, a household of two might spend as little as $410.60 on a month’s worth of groceries or as much as $815.60, a wide range. There are plenty of suggestions online for saving money on a grocery budget, so paying attention to expenditures here and getting creative with meals will probably net some savings to add to a retirement account.
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You can only make so many budget cuts, but you can almost always find ways to make extra money. Whether it’s freelance writing or selling your crafts on Etsy, a side-hustle might be a great way to increase the amount of cash you have on hand to put toward retirement.
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Regular interest-bearing checking and savings accounts are still out there. Even though the interest earned might be minimal compared to investment accounts, it’s still better than not earning interest on those accounts at all.
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If you’re getting a tax return, it may be tempting to spend the money on fun things, but when calculating how to maximize your retirement savings, it’s worth considering funneling some or all of it into your investment account. Saving instead of spending this money could add up to major nest egg increases.
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Aside from housing, car ownership can be one of the most expensive parts of day-to-day living for many people. It’s not just the cost of the vehicle itself, but also insurance, maintenance, and fuel. If you live in the kind of city where you could rely on public transit or take your bike to work, doing so might be a great way to make some substantial monthly savings.
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Assessing your true housing needs is likely a major decision within a household, but if you live in a house that’s bigger than you need or in a pricey part of town, for example, it could be worth it to look at alternatives. Paying less monthly rent, lower taxes or even saving on transportation costs by moving closer to work could lead to substantial savings each month and help maximize your retirement savings.
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Renting can be a good option for certain needs, lifestyles, or periods of your life. But homeowners do tend to accrue more wealth over time. Buying and selling often tends to cost money in closing and moving costs, so if owning a home is something you want to do, buying a home and staying there for a number of years is typically a better way to handle an investment like this.
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While any kind of debt can put an anchor on your retirement goals (and other financial goals, for that matter), credit card debt can be particularly egregious thanks to high-interest rates and compounding, which means you can end up paying interest on the interest you’ve already been charged. By tackling credit card debt and other high-interest debts, you’ll have the opportunity to save more money to put toward retirement.
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This relates indirectly to boosting your retirement savings, but since paying for a child’s college costs can quickly derail a parent’s retirement plan, thinking about this major expense ahead of time can be a wise financial move. Many experts suggest making sure you’ve funded your own retirement accounts before you fund education accounts for your children. Each state operates its own 529 plan, and the terms vary from state to state. The plans are not tax-deductible on a federal tax return, but a 529 plan can offer some tax advantages on the state level depending on the state.
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Any amount you save for retirement will still be a finite amount, which means it’s important to plan ahead of time how you’ll budget for it. Consider the costs of everything, including food, medical care, housing, transportation, and entertainment. Try to envision ways to keep your cost of living low so each dollar goes further once you get there.
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No matter how much you’re able to save for retirement, the money will go a lot further if you retire somewhere with a lower cost of living. If you have decades before your retirement date, it may be difficult to predict what the cost of living will look like in different places, but start to think about which locations might offer all the lifestyle factors you want while also being affordable.
Related: Cost of Living per State (2022)
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Once you reach age 50, the contribution caps on your IRA and 401(k) go up substantially, by $1,000 for IRAs and $6,500 for 401(k)s, in 2022. Maxing out these larger retirement caps can help you increase retirement savings you’ve fallen behind on or rebuild retirement savings you cashed out for something else.
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For many of us, this step might not be coming up anytime soon. But once you’re eligible for Social Security retirement benefits, delaying it might give you a larger monthly benefit during retirement.
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Saving for retirement might be challenging, but it’s not impossible. Stretching every dollar as far as you can will make it a lot more doable. Like so many other financial goals, it all starts with your budget, and budgeting is a lot easier to do when you have a bird’s-eye view of your finances.
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