There are many different tax-advantaged accounts available to American workers. Two that frequently get confused are the Roth IRA and the Roth 401(k). After all, they are both 'Roth' accounts, right?
Today we are going to compare and contrast these two accounts and permanently dispel any confusion in your mind.
They are Both 'Roth,' Right?
Yes, both of these accounts have the 'Roth' prefix, which designates that you need to use post-tax dollars to contribute to the accounts. You pay the taxes now, contribute to the Roth account, let your investments grow, and withdraw the money later tax-free. Roth = taxes now, none later.
Let us contrast the Roth against 'Traditional' or 'pre-tax' investing accounts. As you might expect, pre-tax accounts allow you to contribute dollars before paying taxes on them, thus decreasing your tax burden today. The trade-off is that you will have to pay taxes on your withdrawals in the future. Traditional = taxes later, none now.
But let us get back to talking about the Roth IRA and the Roth 401(k).
Roth 401(k) - Basics, Pros, and Cons
Roth 401(k) accounts were created by federal legislation in 2001.
Like traditional 401(k) accounts, Roth 401(k) accounts are intrinsically tied to your employer. They allow contributions directly from your paycheck. And your employer can also choose to contribute a match (a.k.a. free money!).
For 2020 and 2021, Roth 401(k) participants can contribute an annual maximum of $19,500. They can also contribute an additional $6,500 catch-up contribution if they turn 50 by the end of the year.
Roth 401(k) Advantages
Roth 401(k)s have a few distinct advantages.
For one, they have no upper income limit. The lack of an upper income limit makes Roth 401(k)s an excellent choice for high-income individuals. Additionally, the contribution limits on a Roth 401(k) are significantly higher than those of its IRA counterpart.
Another perk is the 'employer match' that we mentioned above. Many employers will give you matching funds as long as you save using the company's 401(k). We highly recommend you fully take advantage of this matching money from your employer.
Note: the matching funds from your employer are pre-tax dollars, meaning that they must go into a Traditional 401(k) account. When you start taking distributions in retirement, you will need to pay some taxes on this money.
You are paying a fractional tax on free money. It is still a great deal for you!
Finally, Roth 401(k) dollars fall under the rules of the overall 401(k) plan, which means there are some restrictions but also access to features like a 401(k) loan which is not available in an IRA account.
Roth 401(k) Disadvantages
Roth 401(k)s have their downsides.
For example, most people must start taking distributions from their Roth 401(k) before age 72. This requirement is the so-called required minimum distribution or RMD. It should be mentioned, however, that RMD’s will not begin until you have left employment. Upon separation from employment (retirement or otherwise), you also have the ability to roll funds from your 401(k) into a Roth IRA account, which is then not subject to RMD’s.
As with all 401(k) accounts, your investment choices are often limited. You can only choose from the options that your employer and plan administrator have selected. There are also additional rules, as set by your employer, associated with 401(k) money. Frequently, there are restrictions on accessing the funds prior to full retirement age.
Roth IRA - Basics, Pros, and Cons
Roth IRAs (individual retirement accounts) were created by federal legislation in 1997---and named after U.S Senator William Roth of Delaware.
For 2020 and 2021, Roth IRA participants can contribute an annual maximum of $6,000 with the additional catch-up contribution of $1,000 after age 50.
Many of the advantages and disadvantages of Roth IRAs are especially noticeable when compared to the Roth 401(k).
Advantages of Roth IRA
For example, Roth IRAs have no RMD requirement ever, unlike the Roth 401(k)s which require RMDs starting at age 72. In other words, Roth IRAs give you more control over your dollars in retirement. This is why those who had originally funded Roth 401(k)s during their working careers frequently elect to roll over to Roth IRAs in retirement.
The lack of RMDs is conducive for those building generational wealth. Set up correctly, you can pass your Roth IRA to your heirs without incurring any tax penalty.
Roth IRAs also provide flexibility in your investment choices. Since you (not your employer) set up a Roth IRA, your investment choices are relatively unlimited. You can choose the precise asset and funds you prefer, and shop around for the lowest fees on the market.
One more flexibility that Roth IRAs afford: you can withdraw your contributions at any time without facing a penalty. While this is not ideal for your growing portfolio, life sometimes throws us curveballs where we need access to that money now. Contributions to Roth 401(k)s are also not subject to penalty, but your employer may restrict you from drawing the funds while still working.
Disadvantages of Roth IRA
Roth IRAs are not perfect. For example, the $6,000 annual contribution limit is disappointing compared to the $19,500 limit for Roth 401(k) accounts.
But perhaps the biggest downside of Roth IRAs is that you cannot contribute to them if you earn too much money. For 2021, those caps are $140,000 for individuals and $280,000 for married couples filing jointly.
The upper income limit means that Roth IRAs are perfect early-career investment vessels for many career trajectories but might not be available in later years.
Note: if you lose eligibility to contribute to a Roth IRA, the contributions you have made in previous years are perfectly safe! The cap prevents you from contributing more money but does not affect what you have already contributed.
Final Thoughts on Roth 401(k) and Roth IRA
Roth 401(k)s and Roth IRA are excellent retirement accounts depending on your long-term goals.
While each has its flaws---e.g., RMDs, limited investment options, income-dependent access, etc.---the long-term tax savings provided by the Roth infrastructure can be a terrific boon to your portfolio growth.