What’s the Difference Between a Roth IRA & a Roth 401(k)?

The life expectancy of Americans has grown steadily over the past century — so much so that the average American lives 10 years longer today than they did in the 1960s. Even though Congress has since raised the social security retirement age, they haven’t raised it enough to balance the increase in life expectancy, which means Americans are spending more time in retirement than in years past.

Although this trend in longer lifespans is good news, it can be troubling from a financial perspective. The more years Americans spend in retirement, the more assets they’ll need to fund that retirement. Fortunately, there are countless ways to save money for later in life. To help with the task of selecting the right retirement plan, we’ll dive into the details of two popular plans: Roth IRAs and Roth 401(k)s.

What Are Roth Retirement Accounts?

Roth retirement accounts are different from traditional retirement accounts in two main ways.

1) Contributions are made with after-tax dollars. In contrast, traditional retirement accounts are funded with pre-tax dollars.

2) Withdrawals are generally tax free. Withdrawals of both principal and earnings are generally tax free when taken from a Roth account. This effectively allows taxpayers to permanently exclude income tax on Roth earnings. In contrast, withdrawals from traditional retirement accounts are taxable. This lets taxpayers defer income tax on traditional IRA or 401(k) earnings until retirement, but those earnings will be taxed when withdrawn.

What’s the Difference Between Roth IRAs & Roth 401(k)s?

Roth IRAs and Roth 401(k)s share all the characteristics we’ve already discussed — contributions are made with after-tax dollars and earnings grow tax free — but that’s where their similarities end. Roth IRAs and Roth 401(k)s differ in the following ways:

Who Provides Them

401(k)s are employer-sponsored plans, while IRAs can be opened by any individual. This means that Roth 401(k)s are available to fewer taxpayers. Even taxpayers whose employers offer Roth 401(k)s will need to wait until they become eligible to participate, which can take between one and three years.

Who Can Contribute to Them

Only the individual can contribute to their Roth IRA; no other person (employer, family member, etc.) can contribute to their plan. In Roth 401(k)s, the individual can contribute to their own plan, and their employer can make matching or nonelective contributions if they so choose.

Contribution Limits

In 2022, Roth IRAs have a $6K annual contribution limit (or $7K if age 50+). The Roth 401(k) contribution limits are much higher. Roth 401(k)s face two separate annual contribution limitations:

1. The amount employees can elect to defer from their paychecks
2. The overall limit on contributions, which might include employee deferrals and employer contributions

In 2022, employees can make salary deferrals into their Roth 401(k) plans of up to $20.5K (or $27K if age 50+). Overall annual contributions cannot exceed the lesser of 100% of the participant’s compensation (or $61K (or $67.5K if age 50+).

Investment Options

The investment options in a Roth 401(k) are limited to those that have been preselected by the administrator of the retirement plan. Roth IRAs don’t have those same limitations. While most IRA providers have a predetermined list of investment options, their lists are typically less restrictive, and taxpayers are free to shop around until they find an IRA provider that offers the investments they want.

Required Minimum Distributions

Roth 401(k)s are subject to required minimum distributions (RMDs) at age 72, while Roth IRAs are not.

Income Limits

When a taxpayer’s adjusted gross income (AGI) hits a certain number, they will begin to lose their ability to contribute to a Roth IRA. Their permitted contribution (i.e., $6K or $7K, depending on age) will shrink as their income surpasses a certain threshold, and once their AGI reaches a predetermined upper threshold, they will lose their ability to contribute to a Roth IRA altogether.

Roth 401(k) plans have no such income limits on contributions. Even high earners can contribute to Roth 401(k)s.

Below is a table that lists both the upper and lower AGI thresholds that taxpayers should consider if they want to open a Roth IRA. If their income is somewhere between or above these thresholds, they should consider another type of retirement plan.

Roth IRA Contributions: AGI Limits

Should I Use a Roth IRA or a Roth 401(k)?

It’s important to talk with a tax planning professional to understand all the tax implications of your decision, but here are a few general rules to follow:

• Roth 401(k)s are typically better for high earners because there are no income limits.
• Roth 401(k)s are preferred by people who started to save for retirement later in life because the contribution limit is higher.
• Roth 401(k)s that offer matching contributions almost always win out over Roth IRAs because matching contributions cost the participant nothing.
• Roth IRAs allow investments to grow longer because they are not subject to RMDs, which may be good for taxpayers hoping to leave their retirement savings for their heirs.
• Taxpayers who are in a less-than-stable financial position may prefer a Roth 401(k) because they can borrow from their account. They can take a loan of up to 50% of their Roth 401(k) balance (maximum of $50K). They will owe interest on this loan, but because they are borrowing money from themselves, those interest payments will be deposited into their Roth 401(k) account. If those loans are repaid timely, there are no negative tax consequences.
• Taxpayers can take tax- and penalty-free withdrawals from their Roth IRA (even before they reach retirement age) as long as they pull from the amount they’ve contributed. This makes the Roth IRA a good solution for somebody wanting to build a secondary emergency fund.

The ideal retirement plan will be different for everyone because each person’s blend of earnings, investments, family support, health outlook and inheritance goals is unique. Talk to your tax planner to see which of these options (or any of the other retirement options) is best for you.