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Roth 401k vs. Roth IRA – The Key Differences

Roth 401k vs. Roth IRA: Which is Better for You?

We consistently hear from clients that saving for retirement tops the list of their most important financial goals. So it’s a big decision, and a highly personal one, to determine exactly how to go about saving and investing for your future. Part of this is deciding what type of retirement account(s) to save into. There are any number of accounts available – there’s the 401k, Roth 401k, IRA, Roth IRA, SEP IRA, SIMPLE IRA – depending on who you are and what your employer offers, there will likely be several options available to you. This is always going to be a personal call, and your advisor can help you make a decision that’s best for your financial goals and tax situation.

Roth accounts are becoming increasingly popular for retirement savings as they allow your savings to grow tax-deferred. There are two major types of Roth accounts: the Roth 401k and the Roth IRA. People are often confused by these two accounts, and we commonly get questions like: How are they different? How are they similar? If I’m looking for a Roth-type account, which one is right for me? In this article, I’ll break down these two account types and hopefully answer all of these FAQs. If you’re interested in other types of retirement accounts, here are some resources you might find useful:

Do you have enough in your 401k to retire when you want?
  1. Can I Contribute to a 401k and an IRA?
  2. Tips to Max Out Your 401k
  3. Traditional vs. Roth IRA
  4. Roth vs. Traditional 401k

But for now, let’s dive into the Roth 401k and the Roth IRA.

What is a Roth 401k?

A Roth 401k is an employer-sponsored retirement plan. But unlike a traditional 401k, contributions are made with after-tax dollars.

And now for a little bit of history — the Roth 401k was introduced in 2006 to give Americans a new type of retirement savings vehicle to complement the popular Roth IRA, which was introduced in 1997. Roth IRAs and Roth 401ks are similar, but there are some pretty significant differences you should understand when deciding which one is right for you.

Roth 401k vs. Roth IRA: How are They Similar?

Before we look at the differences between Roth IRAs and Roth 401ks, let’s look at the similarities. Here’s the big one: with both of these accounts, your investments grow without the burden of taxation. This can mean a larger nest egg when you decide you’re ready to retire.

Also, in most circumstances, you can withdraw money from both a Roth IRA and a Roth 401k income tax-free after you turn 59 1/2. Practically, this means favorable tax treatment in retirement, since you won’t have to pay taxes on the distributions you take after you hit 59 ½.

With a Roth IRA, you can withdraw contributions penalty-free, but earnings will generally be taxed and penalties assessed on any withdrawals made before age 59½, with a few exceptions/
With Roth 401ks, withdrawals before age 59½ are usually taxed and assessed a penalty, but there are ways to avoid this (401k loans, for example).

Read More: When Can I Withdraw From My 401k or IRA Penalty-Free?

Roth 401k vs. Roth IRA: The Differences

The biggest differences between a Roth 401k and a Roth IRA are their different annual contribution limits, eligibility criteria, and whether or not you will need to take required minimum distributions (RMDs).

Let’s start with the annual contribution limits.

In 2020, you can contribute up to $19,500 per year — and a catch-up contribution of $6,500 per year if you’re 50 years of age or over — to a Roth 401k. However, the annual contribution limit for Roth IRAs is much lower: just $6,000 per year, or $7,000 if you’re 50 years of age or over.

Another big difference between the Roth 401k and the Roth IRA is the eligibility criteria. If you make too much money, you can’t open or contribute to a Roth IRA. More specifically, if your modified adjusted gross income (MAGI) is above $139,000 (if you are single, head of household, or married filing separately and you didn’t live with your spouse during the year) or $206,000 (for married couples filing jointly) in 2020, you aren’t eligible for a Roth IRA.

With Roth 401ks, the only eligibility criteria is that your employer offers this option.

Another big difference is that you don’t need to take Required Minimum Distributions (RMDs) from Roth IRAs. But with Roth 401ks, you must start taking RMDs when you turn 70½ years old.

Pros and Cons of a Roth 401k

A big advantage that the Roth 401k has over the Roth IRA is the possibility of an employer matching your contributions up to a certain percentage. Employer matches are the closest thing there is to “free money,” so if you’re deciding between a Roth 401k vs. a Roth IRA — keep this in mind. It’s also important to note here, though, that if you receive an employer Roth 401k match, the matching funds will go into a traditional 401k.

Some cons, however, are that Roth 401k accounts typically have fewer investment options than a Roth IRA.

If you aren’t happy with the investment options your 401k plan offers, here’s one strategy to consider: contribute enough money to your Roth 401k to receive the company match, since this match represents a risk-free return on your investment. Then you can also open a Roth IRA and contribute any additional retirement money you have to this account in order to diversify your retirement savings.

Pros and Cons of a Roth IRA

On the flip side, Roth IRAs generally offer more investment options than Roth 401ks. With a Roth IRA, you have the entire universe of investments to choose from, including stocks, bonds, cash equivalents and alternative investments. With a Roth 401k, you are limited to the investment options offered by your employer’s 401k plan, which can be as few as three.

However, one con of a Roth IRA is the income limit associated with this type of account. If you earn too much money, you won’t be able to contribute to one. Roth IRAs also aren’t sponsored by an employer, which means that there is no match.

Choosing Between a Roth 401k and a Roth IRA

As with anything financial planning, there’s really no one-size-fits-all answer to this question. The best way to figure out which account makes more sense for you is to talk to your financial advisor about your specific situation, but here are a few scenarios to help guide your conversation.

A Roth 401k might be the better choice if…

  • You earn too much money to open and contribute to a Roth IRA.
  • You want to take advantage of an employer match.
  • You want to contribute as much money as possible.
  • You appreciate the ease of signing up at work and having contributions automatically deducted from your pay each pay period.

A Roth IRA might be the better choice if…

  • You want access to a wider range of investment options.
  • You want to be able to withdraw contributions tax- and penalty-free before you turn 59½ without making a plan loan.
  • You don’t want to have to take RMDs when you turn 70½.

Weighing the Pros and Cons

Roth IRAs and Roth 401ks are both good options for retirement savers. The answer to which account is the better option will really depend on your unique situation. It’s always a good idea to talk to your financial advisor to weigh the pros and cons and come up with what the best choice is for your situation.

Next Steps for You

  1. To get a complete picture of your retirement, and to help you plan for the future, sign up for a free online tool like Personal Capital. Personal Capital’s Retirement Planner will allow you to form a personalized retirement plan and see how likely you are to meet your goals, for free.
  2. Consider talking to a fiduciary financial advisor to help guide you through these types of important retirement decisions.

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

Ian Wymore is a Senior Financial Advisor at Personal Capital and is committed to helping clients achieve their best financial outcomes. Ian has several years of experience working with high net worth individuals and families. Prior to Personal Capital, Ian worked at Morgan Stanley Wealth Management.
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