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Roth 401(k) vs. Roth IRA: What’s the Difference?

Roth 401(k) vs. Roth IRA: An Overview

There is no one-size-fits-all answer as to which is better, a Roth 401(k) or a Roth IRA. It all depends on your unique financial profile: how old you are, how much money you make, when you want to start withdrawing your nest egg, and so on. There are advantages and disadvantages to both. Here are the key differences you should consider when comparing the two types of Roths.

Key Takeaways

  • Roth IRAs have been around since 1997. Roth 401(k)s came into existence in 2001.
  • A Roth 401(k) has higher contribution limits and allows employers to make matching contributions.
  • A Roth IRA allows your investments to grow for a longer period, offers more investment options, and makes early withdrawals easier.

How a Roth 401(k) Works

Created by the Economic Growth and Tax Relief Reconciliation Act of 2001, Roth 401(k)s are a hybrid, blending many of the best parts of traditional 401(k)s and Roth IRAs to give employees a unique option when it comes to planning for retirement.

Like traditional 401(k)s, contributions are made directly from an employee’s paychecks and the employer may match part of those contributions. Like Roth IRAs, the income taxes are paid on that money before it goes into the account, so withdrawals will not be subject to income tax down the line.

Roth 401(k) Advantages

A big advantage of a Roth 401(k) is the absence of an income limit, meaning that even people with high incomes can still contribute. This pairs well with the Roth 401(k)’s higher contribution limits.

Participants in the plans can contribute an annual maximum of $19,500 for 2021 ($20,500 for 2022), with an additional $6,500 catch-up contribution if they turn 50 by the end of the year.

Unlike Roth IRAs, Roth 401(k)s do not have an income limit, allowing high-wage earners to contribute to one.

1. An Employer May Contribute

The biggest advantage to Roth 401(k)s is the possibility for matching contributions from an employer. Employers are even offered a tax incentive to make them.

There is a hitch, though. Because employers are matching your contribution with pretax dollars, and the Roth is funded with post-tax dollars, the matching funds and their earnings will be placed in a regular 401(k) account. That means you will pay taxes on this money—and its earnings—once you start taking distributions.

2. Loans Are Allowed

A third advantage is the ability to take a loan from your Roth 401(k) account. You can borrow up to 50% of your account balance or $50,000, whichever is smaller.

However, if you fail to pay back the loan as per the terms of the agreement, that money could be considered a taxable distribution.

Roth 401(k) Disadvantages

With a Roth 401(k), you must begin taking required minimum distributions (RMDs) once you reach the age of 72, as you must with a 401(k) or a traditional IRA. If you don’t, you are subject to a financial penalty. The only circumstances under which you can hold off taking RMDs is if you are still working and are not a 5% owner of the company sponsoring the plan.

Your investment options are limited with a Roth 401(k) to those offered by the plan administrator. In many cases, these boil down to a few basic mutual funds (one growth-oriented, one income-oriented, one money market, etc.). You’re also stuck with the expense ratios—often somewhat high—in 401(k) plan funds, and, of course, the plan administrators get their cut each year too.

Finally, access to the funds in your Roth 401(k) before age 59½ is limited. Tapping nest eggs before retirement should always be a matter of last resort, but if you must do it, you can’t take cash out of your Roth 401(k) without incurring a 10% penalty.

How a Roth IRA Works

Roth IRAs were established by the Taxpayer Relief Act of 1997 and named for Senator William Roth of Delaware. What sets them apart from traditional IRAs is that they are funded with after-tax dollars, making qualified distributions tax-free.

Roth IRA Advantages

One big advantage of the Roth IRA is that it does not require you to take RMDs—ever. That flexibility gives you the option to keep contributing to your account and letting those funds grow indefinitely, which is beneficial if you do not need them at age 72.

In fact, you could simply leave your Roth IRA intact and leave it to your spouse or descendants. “A Roth IRA will typically pass tax-free to your heirs, as long as the Roth IRA account does not pass through probate. Probate can be avoided by ensuring that beneficiaries are specified correctly,” says Christopher Gething, a chartered financial analyst and founder of Atherean Wealth Management in Jersey City, N.J.

Be aware, though, that any money in a Roth IRA that is willed to a beneficiary will be subject to RMDs. The rules are different for surviving spouses and other beneficiaries. They will face a 50% penalty if they don’t take the distributions as required, so it pays to understand the rules—and make sure your beneficiaries do, as well.

1. Wide Range of Investment Options

Another big advantage of a Roth IRA is the wide range of investment options. The entire asset world is your oyster (a few exotic investments aside).

Also, you can shop around to see which custodians and vehicles carry the smallest transaction and administrative expenses.

2. Flexible Withdrawals

A final advantage is greater flexibility with preretirement withdrawals. You can withdraw an amount equivalent to the contributions you have made at any time without penalties or taxes. This does not, however, apply to Roth IRA’s earnings, for which preretirement withdrawals (if you’re under 59½) do come with a 10% penalty.

However, under certain circumstances, such as buying a home for the first time or incurring childbirth costs, you can withdraw earnings from your Roth IRA free of penalty if you’ve held the account for under five years, and free of penalty and taxes if you have held it for more than five years.

Roth IRA Disadvantages

Roth IRAs come with an income limit. As per the IRS, individual taxpayers who make $140,000 or more in 2021 ($144,000 for 2022), or married couples filing jointly who make up to $208,000 or more ($214,000 for 2022), are not eligible for Roth IRA contributions.

Roth IRAs also have a lower contribution limit—$6,000 per year (for 2021 and 2022), compared to $19,500 in 2021 ($20,500 for 2022) for a Roth 401(k)—and do not allow for matching contributions.

Unlike Roth 401(k)s, Roth IRAs don’t allow loans. However, there is a way around this: initiate a Roth IRA rollover. During this period, you have 60 days to move your money from one account to another. As long as you return that money to it or to another Roth IRA in that time frame, you are effectively getting a 0% interest loan for 60 days.

Can I Take a Loan From My Roth IRA?

Technically, no. There is no provision for borrowing against your Roth IRA, only for taking qualified or non-qualified distributions. However, if you initiate a Roth IRA rollover, you have 60 days to use that money at 0% interest before depositing it in your new account, which is essentially a short-term loan.

Can I Have a Roth 401(K) and a Roth IRA at the Same Time?

Yes, as long as you meet all income limits and restrictions, you can contribute to both types of a Roth at the same time. The contribution limit for each is different—$20,500 for a Roth 401(K) and $6,000 for a Roth IRA in 2022. Both types of account have catchup contributions for people over age 50: an additional $6,500 for a Roth 401(k), and an additional $1,000 for a Roth IRA in 2022.

Can I Choose My Investments in a Roth 401(K)?

Because a Roth 401(K) is an employer-sponsored plan, your choice of investments will be limited to what the corporate structure has decided. A Roth IRA, on the other hand, is simply the tax shelter for a wide range of investments.

The Bottom Line

When comparing a Roth IRA with a Roth 401(k), each has its own set of perks and benefits. Neither is inherently better than the other.

Indeed, it may help you at some point to switch between them. For example, says Gething, “You can easily avoid required minimum distributions by rolling over your Roth 401(k) to a Roth IRA.”