The Roth IRA, a retirement plan option for more than 25 years, was joined in 2006 by the employer-sponsored Roth 401(k) plan, also known as a “designated Roth account.” Both accounts offer taxpayers tax-advantaged savings, but it’s important to understand how they compare and all of the tax implications before jumping in. Here’s what you should know.
The Similarities
Contributions to both accounts are made with after-tax dollars from your earned income (for example, wages or salary) and grow tax-free. You generally can withdraw “qualified distributions” tax-free as long as you’ve held the account for at least five years. Qualified distributions are those made:
- On account of disability,
- On or after death, or
- After you reach the age of 59½ years.
Both accounts carry a 10% early withdrawal penalty, but several exceptions may apply. You can also withdraw contributions to a Roth IRA or Roth 401(k) without incurring tax or an early withdrawal penalty before age 59½ (you’ll have to pay tax and penalties on the proportionate earnings, though).
The Differences
Perhaps the most significant difference lies in the amount you can contribute to the respective accounts. For starters, contributions to a Roth IRA are subject to income limits — a modified adjusted gross income of less than $161,000 for single taxpayers and $240,000 for married taxpayers. No income limits apply to Roth 401(k)s.
Moreover, you can put much more into a Roth 401(k). For example, in 2024), contributions to a Roth IRA are limited to $7,000, or $8,000 if you’re age 50 or older (up from $6,500 and $7,500 respectively for 2023). Click here to learn the maximum contribution amount allowed for this year, as well as the “catch-up” contribution amount for those over age 50. And, if you have a Roth 401(k), your employer might make matching contributions (such contributions must go into a traditional 401(k), so withdrawals will be taxable).
On the other hand, you can withdraw from a Roth IRA without tax or penalty for a first-time home purchase (up to $10,000), qualified birth or adoption expenses (up to $5,000), and qualified higher education expenses (with no limit).
You also might wonder about the role of required minimum distributions (RMDs). Roth 401(k)s have had annual RMDs since their creation, like traditional 401(k)s and IRAs. But, beginning in 2024, Roth 401(k)s won’t be subject to RMDs until the death of the owner. Roth IRAs also don’t require withdrawals until after the death of the owner.
The Tax Considerations
Like any retirement saving option, Roth IRAs and Roth 401(k)s come with potentially negative tax consequences. Most prominent among those is that you don’t get the immediate tax deduction that you’d get from contributing pretax dollars to a traditional IRA or 401(k). As a result, you won’t reduce your taxable income for the years you make contributions.
This immediate disadvantage may be outweighed by the future savings reaped from paying no tax on withdrawals and avoiding RMDs. The tax benefits may be especially appealing if you expect to be subject to a higher income tax rate in retirement than you are when you contribute.
The savings can go beyond just your income tax bill. For example, lower taxable income in retirement can reduce the amount you must pay for Medicare premiums and the tax rate on your Social Security benefits.
Conversely, you might have reasons to prefer reducing your current taxable income. It could increase the amount of your Child Tax Credit, which phases out at certain income thresholds, as well as the amount of financial aid you can secure for your children for college.
Don’t Go It Alone
Of course, assuming your employer offers a Roth 401(k), you can contribute to both types of accounts. Ultimately, the best option may prove to be a combination of accounts that will provide taxable and tax-free distributions in retirement. Your financial advisor can help you chart the right course for your circumstances and priorities.
