A Roth 401(k) and a Roth IRA sound similar — and they are.
Contributions are made after taxes — meaning your taxable income isn’t reduced by the amount of your contributions when you file your taxes. But you get a tremendous tax advantage down the road, since earnings can be taken out tax-free at age 59 1/2. But the Roth 401(k) has a few key differences from the Roth IRA.
1. Contribution amounts
The most distinguishing characteristic of 401(k)s, whether Roth or traditional, is the high contribution limit, allowing employees to save up to $18,500 per year in 2018. For workers over 50, the ceiling is $24,500.
Meanwhile, IRA contribution limits are $5,500, and workers over 50 may contribute up to $6,500 per year.
A benefit of the Roth IRA is that the account can exist, essentially, forever without any minimum required distributions.
“The Roth IRA can be passed down to the next generation and provide tax-free earnings for that generation and the next,” says Dean Barber, founder and CEO of Barber Financial Group.
A Roth 401(k), on the other hand, will require distributions starting at age 70 1/2 unless you’re still working for the company sponsoring the plan – as long as you don’t own 5 percent or more of the business. If you’re retired and you need the money, you may not mind taking the distributions. But there is a way around it if you prefer to keep your savings working for you tax-free. In that case, account holders can roll the account over from a Roth 401(k) to a Roth IRA. Easy Peasy.
3. The match in a Roth 401(k)
Besides their high contribution limits, Roth 401(k)s have another advantage: The worker’s contributions can be matched by the employer up to a certain percentage. It’s essentially free money from the employer, on top of the employee’s elective deferrals.
However, if you are contributing to a Roth 401(k), the match portion of the contribution will be treated as a traditional 401(k) contribution because it goes in pretax.
“The employer part never reaches you, so it can’t be done on an after-tax basis,” Barber says.
That means that every Roth 401(k) account essentially has a traditional component if the employer provides matching contributions to that account.
For workers who divide contributions between a regular 401(k) and a Roth 401(k), the company match will be applied to the traditional 401(k).
4. Investment options
A Roth IRA allows investors a great deal more control over their accounts than a Roth 401(k). Investors can choose from the universe of investments for their own accounts, including individual stocks and bonds, but are limited to the funds their employers offer in a 401(k) plan.
Depending on their plan’s investment menu, employees might be better off maximizing the match from their employer and then funneling extra retirement dollars into a Roth IRA. That way they can take advantage of better investment options if the fund lineup is too limited in the employer’s plan.
Also check the expense ratios of the funds in your Roth 401(k) plan. The lower the expense ratio, the higher your return. Last year investors paid an average of 0.52 percent for their mutual funds and exchange-traded funds, according to Morningstar Research Services. If the funds in your 401(k) plan run higher than 1 percent, strongly consider investing in a Roth IRA.
5. Income limits
Roth IRA contributions are off-limits if your modified adjusted gross income in 2018 is $199,000 or more for married couples filing jointly or $135,000 or more for single filers.
Meanwhile, there are no income limits on Roth 401(k)s.
6. Rules for early withdrawals
Withdrawals from both Roth 401(k)s and Roth IRAs are tax free if they meet certain criteria:
- The accounts must be held for at least five years.
- Distributions are made in the event of disability or death or the account holder reaches age 59 1/2.
You can always take out the money you contributed to either Roth account without tax repercussions. But if you want to take out earnings as well as contributions early without paying taxes or an early-withdrawal penalty, you generally would have to take out a loan with the Roth 401(k) if the plan permits.
With a Roth IRA, you can withdraw up to $10,000 to buy, build or rebuild a first home and avoid paying taxes and the 10 percent early withdrawal penalty even if you are under age 59 1/2.