Most people are aware of the tax-free benefits of the Roth IRA.
But what many people may not know is that their company retirement plan probably offers a Roth option as well--the Roth 401(k).
The Roth 401(k) offers most of the same features and benefits of the Roth IRA. Contributions are made on an after-tax basis. Earnings grow tax-free, and withdrawals made after age 59½ are tax free as well. (Both Roth IRAs and Roth 401(k)s require you to own these accounts for five years before you can enjoy these tax-free benefits.)
But there are important differences.
First, investors can only make contributions to a Roth IRA if their modified adjusted gross income (MAGI) is below a certain level. And annual IRA contributions are capped at $6,000 per year plus an additional $1,000 in “catch-up” contributions for those over age 50.
The restrictions are much looser for Roth 401(k)s. All retirement plan participants, regardless of income, can make both pre-tax contributions to their regular 401(k) account and after-tax contributions to their Roth 401(k) account, up to a maximum combined total of $19,500 per year, plus up to $6,500 in additional “catch-up” contributions.
Employers can match Roth 401(k) contributions, although these matches must be made to a pre-tax account (which means these contributions and any earnings will be taxable when withdrawn).
However, there are some potential drawbacks for contributing to a Roth 401(k). Required minimum distributions (RMDs), for one thing. With a Roth IRA, you never have to take RMDs. With a Roth 401(k), you must start taking RMDs at age 72 if you’re no longer working.
If you’ve established your Roth IRA as a brokerage account you’ll be able to invest in stocks, bonds, ETFs and possibly thousands of mutual funds, including lower-cost index funds. With a Roth 401(k), your investment options will be limited to those available in the plan, and investment expenses may be higher.
Below is a chart that summarizes the main differences between the two Roth options. (Note dollar figures are for 2021 and may change in 2022.)
So…which one is best?
That’s a trick question, because the answer really depends on your situation.
A Roth IRA may be a better choice if:
- Your MAGI level allows you to make Roth IRA contributions.
- You want to have access to the widest variety of investment options.
- Controlling investment expenses is a priority.
- You don’t want to take RMDs.
A Roth 401(k) may be a better choice if:
- Your MAGI is too high to allow you to make Roth IRA contributions.
- You want to contribute more than $6,000 each year to your Roth account.
- You want to maximize employer matching contributions for both your pre-tax and Roth 401(k) contributions.
- You want your contributions withdrawn automatically from your paycheck.
How about contributing to both?
If your MAGI qualifies you to make Roth IRA contributions, consider contributing to both a Roth IRA and Roth 401(k). You could make the maximum annual after-tax contribution to your Roth IRA, and then make additional after-tax contributions to your Roth 401(k). If you only make after-tax Roth contributions in 2021 you could put away a combined total of $25,500 ($33,000 if you can also maximize "catch-up" contributions).
With this approach, you could choose to pass on all of your Roth IRA assets to your spouse or heirs tax-free, and then use your Roth 401(k) assets to provide tax-free income during retirement.
Get professional help
Of course, these decisions are not always clear cut. Your age, your tax situation, your retirement income needs and your estate planning priorities should influence which Roth option makes more sense—or if you might be better off contributing more to your pre-tax 401(k) plan account. That’s why you may want to work with a financial advisor to evaluate all of your retirement savings options.
This material has been provided for general informational purposes only and does not constitute either tax advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult an accountant or tax advisor.
This article was authored by Eric Kristenson and Jeffrey Briskin. Eric is a Retirement Plan Consultant located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or email@example.com. Jeffrey Briskin is Director of Marketing at Canby Financial Advisors.
©2021 Canby Financial Advisors