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

While many people are familiar with the concept of a Roth IRA, the Roth 401(k) plan is a relatively new player on the retirement scene. Even so, it has been growing quickly since its birth in 2006. A 2018 study by consulting firm Willis Towers Watson of 349 medium- and large-sized companies found that 70% now offer a Roth 401(k).

Roth 401(k)s blend many of the best parts of traditional 401(k)s and Roth IRAs, giving employees a unique option when it comes to planning for retirement. Like traditional 401(k)s, they allow for employer matches and for contributions made directly from paychecks. Like Roth IRAs, their distributions are not subject to income tax.

But are they better than Roth IRAs? That 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. Here are the key differences you should consider when comparing the two types of Roths.

Roth 401(k)s

Roth 401(k)s are a Roth IRA/401(k) hybrid. This has advantages and disadvantages. One advantage for Roth 401(k)s is the lack of an income limit, meaning 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 a maximum of $19,000 per year, with an additional $6,000 catch-up contribution if you turn 50 by the end of the year, as of 2019.

Another advantage to Roth 401(k)s is the possibility of matching contributions. Like with 401(k)s, employers can make matching contributions to a Roth 401(k) plan and are even offered a tax incentive to do so. But there is a hitch. Because employers are matching your contribution with pre-tax dollars, and the Roth is funded with post-tax dollars, those 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.

Roth IRAs

Roth IRAs cede the advantage in some areas to Roth 401(k)s, as Roth IRAs have an income limit while Roth 401(k)s do not. Per the IRS, individual taxpayers who make $137,000 or more, or married couples filing jointly who make $203,000 or more, are not eligible to make Roth IRA contributions in 2019. To determine if you qualify, check out this Roth IRA calculator. They have a lower contribution limit ($6,000 per year, compared to $19,000 for a Roth 401(k)), and they do not allow for matching contributions.

But Roth IRAs hold the advantage in some key areas. One big advantage is the required minimum distribution of a Roth IRA, namely none. The Roth IRA does not require you to take required minimum distributions (RMD)—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 the funds at age 70½, the age that traditional IRAs, 401(k)s, and Roth 401(k)s all require you to start withdrawing money, lest you suffer a penalty.

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, founder of Atherean Wealth Management, LLC, in Jersey City, NJ.

With the Roth 401(k), you can hold off these RMDs after age 70½ only if you are still working and you're not a 5% owner of the company sponsoring the plan. However, “you can easily avoid required minimum distributions by rolling over your Roth 401(k) to a Roth IRA,” says Gething.

Another big advantage to Roth IRA is the investment options. This issue mirrors the debate between 401(k) plans and IRAs in general. With the former, investors are limited to the options 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.). With IRAs, the entire asset world is your oyster (a few exotic investments aside). And you can shop around to see which custodians and which vehicles carry the smallest transaction and administrative expenses. In contrast, you're 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.

A final advantage is pre-retirement withdrawals. Let's say you need funds and you are under 59½ years old, the magic age at which you can start withdrawing retirement account money without incurring a 10% penalty. While tapping nest eggs for the golden years should always be a last resort, it is at least a little easier to do with a Roth IRA.

With a Roth 401(k), you really cannot withdraw funds without incurring a tax hit. But 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 when you take the money out, it could be considered a taxable distribution.

Roth IRAs offer much easier access. You can withdraw an amount equivalent to the contributions you have made at any time, without penalties or taxes. And if you need a sum above and beyond, Roth IRAs don't technically allow loans, but 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.

Also, under certain circumstances, such as buying a home for the first time, you can withdraw earnings from your IRA free of penalty if you've held the account for under five years, and free of penalty and taxes if you have held for more than five years.

Key Takeaways

  • There is no one-size-fits-all answer to the question "Which is better, a Roth IRA or a Roth 401(k)?" Each has its own unique perks and benefits.
  • A Roth 401(k) tends to be better for high-income earners, has higher contribution limits, and allows for employer matching funds.
  • A Roth IRA lets your investments grow longer, tends to offer more investment options, and allows for easier early withdrawals.
  • If you happen to be searching for the best place to get one of these accounts, Investopedia has created a list of the best brokers for IRAs.