Roth IRA vs. Roth 401(k) – Choose The Best Plan For You

Joseph Meyer
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Table of Contents

  • Introduction
  • Roth IRA vs. 401(k)
  • How to Choose
  • How Much Should I Contribute?
  • Is There an Optimal Age to Open a Roth IRA?
  • Can I Open a Roth Later If I Miss the Annual Limit?

Roth IRA vs. Roth 401(k) – The Similarities

The Roth versions of these accounts do the same thing: they convert income that you put in the accounts into tax-free dollars.

You pay taxes on the money you convert to a Roth, but you don’t pay taxes on the income you earned to contribute to the account. Plus, if you accidentally withdraw the money in a traditional 401(k) before you’re 59 1/2, you have to pay a 10% penalty tax on top of the income tax you owe. With a Roth, that’s not an issue

(although there are exceptions for asset protection): you can withdraw your contributions at any time for any reason with no tax consequences.

Both Provide Tax-free Distributions in Retirement

The IRS treats both plans similarly, and many people find them equally appealing. But both plans aren’t perfect. Before you decide which one to choose, carefully consider the following pros and cons.

A Roth IRA is a bit better for people in higher tax brackets who expect their earnings to increase substantially in the future. Due to the tax deductions that you receive upfront, a Roth 401(k) plan is more beneficial to people in lower tax brackets.

With a Roth IRA, you can also have more control over the investments in your plan whereas you are mostly limited in what you can invest in under a Roth 401(k) plan.

Anyone can contribute to a Roth IRA, even those who participate in a company-sponsored 401(k) plan. Money from a Roth IRA is invested differently…often in stocks…than money from a Roth 401(k) (which is generally invested in safer, more conservative options like bonds and mutual funds).

Opportunities abound, and smart, committed investors with a long-term perspective can make great money with either plan … so long as you stay aware of the IRA laws for Roth accounts vs. Roth 401(k)s.

Neither offers Tax-deductible Contributions

Before diving into a Roth IRA vs. Roth 401(k) comparison, the first thing to do is to make it clear that these accounts are not the same kind of plan. The 401(k) is designed for employers who offer the retirement plan to their employees. Although non-profit organizations can also opt to offer a 401(k) program to their employees, it’s not a legally required part of their employment package.

The IRA, on the other hand, is a retirement plan that’s set up for the individual by the individual. And although it’s structured similarly to the 401(k), they’re actually two very different plans. If you’re looking for a 401(k), be sure to check out some of the other resources on our site.

So, going back to the main question, the Roth IRA vs. Roth 401(k) question, it’s easy to see that neither of these retirement plans is designed for employers or non-profits. Rather, they both allow individuals to put money towards their retirement, with a few key differences.

You can Withdraw Your Contributions from Either Plan at Any Time – Tax-free

First things first: whichever plan you choose to do your regular retirement investing with, you need to make sure that it’s a retirement account. Why— Well, most retirement plans come in two flavors: Traditional and Roth.

The difference between them is how do you pay taxes when you want to have your money. With a traditional plan, you pay tax first and then you can pull your money out. With a Roth account, you pay the tax right now – on your investments – and then you can pull your money out tax-free.

That’s two very different ways of managing your finances. So which one is right for you? Let’s take a look.

Both offer Tax-deferred Investment Returns

The understandable appeal of the Roth IRA is that it allows you leverage a higher contribution based on your earnings. If all the primary conditions are met, then this tax-deferred account is a dream come true. It allows investors to start out with tax-deferred growth and maximizes after-tax investment returns due to the tax free nature of distributions.

The Roth 401(k) accounts can be established by an employer, either as a stand-alone or as an add-on account to the 401(k) plan. It’s available only to employees who have reached the age of 18 or older. The employers can contribute to the Roth 401(k) accounts and can also decide to contribute to the employee’s 401 (k) plan in combination with the Roth 401(k) plan. The employees who are enrolled in the Roth 401(k) plan pay taxes on their earned income but neither on the contributions or interest. There are some withdrawal restrictions for the Roth IRA; they do not apply to the Roth 401(k).

Considerations when comparing the Roth IRA vs. the Roth 401(k)

When you are deciding which type of plan to contribute to, look at the options available because each has distinct features. These include maximum contribution limits, taxation and if you're working, you can’t always contribute to a Roth.

Accumulated Investment Earnings are Taxable if Withdrawn Early

Roth IRA and Roth 401(k) are both tax-deferred retirement plans. This means that you get to put in money for retirement and do not have to pay tax on it.

However, as the name suggests, a Roth IRA has a critical difference compared to a 401(k) that makes it more favorable for some investors. Namely, Roth IRAs allow you to withdraw your deposited contributions and the earnings on them tax-free at any point in time.

The money you contributed to a Roth 401(k) is already part of your contribution limit, which you must keep in mind when considering whether to make a Roth contribution or a traditional contribution to a 401(k). Traditional contributions to a 401(k) allow you to withdraw the contributed amount, as well as the accumulated earnings on this amount, at any point in time without paying tax on the amount. The amount withdrawn from the account, however, is taxed as ordinary income.

Distributions from Either won’t Affect the Taxability of Your Social Security Benefits

Both a Roth IRA and a Roth 401(k) are taken out of the tax base because you contribute after-tax earnings (i.e. income taxed at your normal rate). It’s a common misconception that a distribution from these accounts will not be taxed when you retire. But the truth is that only qualified distributions will be tax-free. These distributions also avoid taxation on gains, and they will count as a tax-advantaged source of income for your Social Security benefit calculation.

Distributions that are not for qualified expenses will be treated as regular income. For example, if you take out a loan from your 401(k), distributions will be taxed as regular income to you, and the credit will reduce your tax liability.

Roth IRA vs. Roth 401(k) – The Differences

Roth IRA and Roth 401(k) are two of the most popular kinds of retirement accounts. While there are similarities in a lot of aspects, there are also some stark differences between the two. If you’re trying to decide which is the right one for you, this post may help you decide if the Roth IRA or the Roth 401(k) is the best option.

Contribution Amounts

Employer Matching Contributions

When it comes to deciding whether to contribute to a Roth IRA or a Roth 401(k), the answer may come down to whether your current employer gives matching contributions. Many employers contribute a certain percentage of your contributions to your 401(k).

Here’s an example: If your employer matches 50% of your contributions up to 6% of your income, you’re contributing 3% on your own, your employer is contributing 2%, and you’re getting another 1% from government tax breaks. If your employer gives you a choice, contributing to a Roth 401(k) amounts to 50% more money than contributing to a Roth IRA … TWICE as much if you meet the income requirements for the Roth 401(k).

Loan Provisions

If you’re lucky enough to work for a company that offers a 401(k), you’re probably torn between enrolling in your 401(k) or opening up a Roth IRA. While both retirement accounts will help you save for your retirement, there are several differences between the two that you should understand before deciding which one is right for you.

Maximum Contributions

Both Roth IRA and 401(k) plans are similar in that you can defer taxes on your contributions. However, the maximum amount that you can contribute to your 401(k), if your employer offers one, is significantly less than the maximum amount that you can contribute to a Roth IRA.

Loan Provisions

If you don’t manage your 401(k) well and you find yourself struggling to make ends meet near the end of the year, you may be tempted to take out a 401(k) loan. However, contrary to popular belief, you cannot take out a 401(k) loan to pay off credit card debts.

On the other hand, a Roth IRA loan doesn’t require you to pay back the amount of the loan. Although they offer the same benefit, a Roth IRA loan differs significantly from a 401(k) loan.

Required Minimum Distributions (RMDs)

When you hit 70 1/2, you have to start taking RMDs, the IRS mandated minimum withdrawals that you’ll be required to make from your IRA accounts after you reach that age. If you don’t take the Required Minimum Distribution, you’ll be penalized 50% for failing to make the withdrawal. And that can add up over the years!

If you have both a traditional IRA and a Roth IRA, you can strategically decide whether to take the withdrawal from your traditional IRA or your Roth IRA when it comes time to make the withdrawal. The caveat: if you take money out of your traditional IRA, you must report it as ordinary income, which means it will be added to your ordinary income for the year and thus increase the taxes you owe that year.

To make the decision, you must first know how much you’re going to receive in RMDs. If your estimated RMDs are far less than the total balance, it makes sense to withdraw the money from the traditional IRA, because you’ll end up paying fewer taxes that year. If you take money from your Roth IRA, the withdrawal will be tax free, since it’s already been taxed. You’ll be treated as if you withdrew the same amount of money from your traditional IRA.

Income Limits

In order to contribute to a Roth IRA or Roth 401(k), your income must be below the annual limits. For 2018, the IRS has continued to raise the thresholds, making it easier for more people to enjoy the benefits of these retirement savings plans.

If your gross income falls within the range specified, you can enjoy the benefits of tax-free growth for your retirement. And while the contribution limits of these accounts vary depending on various factors, below are the basic Roth IRA and Roth 401(k) contribution limits.

Trustee and Investment Selection

An employee can designate a trustee or transfer assets directly to an employer trustee-designated trust. Employer plans can offer more limited access to investments than are available in the individual marketplace. In addition, the employer has the option of only offering one company's investment lineup in his plan.

(Is it just me, or does that sentence sound like it's insulting the customer's intelligence?)

It may be the case that you are allowed to direct the placement of your contributions, or that your plan is one of a group of plans from the same administrator to which you may contribute. In that case you have a bit more flexibility in selecting investment options.

Generally, it is an advantage to have a wide selection of investments, from which to choose, to grow and to have access to those investments beginning at the inception of your account.

There are some drawbacks to commercial plans, however. Though plans offer a wide array of options, your company may only wish to offer one on an exclusive basis so you may not have as much freedom in your investment selection. You may also have a limited window in which to contribute tax-advantaged savings to your account.

Roth IRA vs. Roth 401(k) – Which Will Work Better for You?

If you’re like many people these days, you have the choice of saving money in a Roth IRA or a Roth 401(k). Both plans have similar tax benefits, and both have several rules to follow. How do you select the best plan for you?

An individual retirement account (IRA) is a retirement account that allows you to save and invest money for the future. A Roth IRA is a type of individual retirement account that was established under the provision of the 1997 Taxpayer Relief Act. The Roth IRA was named after Senator William Roth Jr., who introduced the legislation in 1997.

A Roth IRA and a Roth 401(k) have several things in common, but there are also differences between the two. You can figure out which plan(s) are best for you by considering the following:

Fees

Fees can differ depending on which company you choose and where you are in the country. Compare different companies and choose one that offers low fees for the account you select. Roth IRA and Roth 401(k) accounts both have annual fees. Account holders can typically choose between these types of additional fee options:

  • Custodial fee
  • Investment advice fee
  • Trustee fee
  • Expense ratio

Annual fees are used to cover recordkeeping, and tax reporting.

About the Author

Radhika Panchasara is an investment analyst and advisory services manager at Lord Abbett. Her primary responsibility is to analyze mutual funds, series funds, and ETFs. She also manages various advisory services including the 401(k) rollover and IRA rollover services. Prior to joining Lord Abbett, Radhika worked as a Financial Analyst for 5 years at State Street Global Markets (Australia). Radhika holds a degree in finance and a CFA Charter.

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