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 individual retirement account (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.
- Roth individual retirement accounts (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 401(k) is overseen by your company; they select the broker and may limit the investment options.
- A Roth IRA allows your investments to grow for a longer period, offers more investment options, and makes early withdrawals easier.
- A Roth IRA is subject to lower contribution thresholds. In addition, high-income individuals or households may not qualify for Roth IRA contributions.
Roth 401(k) Plans
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. but unlike traditional 401(k) plans, 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 IRAs were established by the Taxpayer Relief Act of 1997 and named for U.S. Sen. 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.
Also, unlike 401(k) plans, a Roth IRA is not sponsored by your employer. This means that you can continue investing in the same Roth IRA, even after you change jobs. Individuals can select the financial institution to hold custody of their IRA, investments they want to contribute money towards, and decide how much they want to fund their account each year.
Both the Roth 401(k) plans and the Roth IRA plans use after-tax dollars, meaning that the owner does not have to pay income taxes when they receive distributions. This can work to the advantage of people who expect to earn more money later in life. Beyond those similarities, there are several key distinctions between a Roth IRA and a Roth 401(k) plan:
Roth IRAs come with an income limit. As per the Internal Revenue Service (IRS), individual taxpayers who make $$144,000 for 2022 or married couples filing jointly who make up to $214,000 for 2022 are not eligible for Roth IRA contributions. These eligibility thresholds are higher in 2023, with eligibility phasing out for individuals making more than $153,000 and couples making more than $228,000.
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.
Required Minimum Distributions (RMDs)
With a Roth 401(k), you must begin taking required minimum distributions (RMDs) once you reach age 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 are if you are still working and are not a 5% owner of the company sponsoring the plan.
A Roth IRA 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. You can also simply leave your Roth IRA intact and leave it to your spouse or descendants.
With a Roth 401(k), your investment options are limited 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.
A Roth IRA has a much wider 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.
Contributions and Contribution Limits
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. Participants in the plans can contribute an annual maximum of $20,500 for 2022 and $22,500 for 2023. Individuals can contribute an additional $6,500 catch-up contribution in 2022 and $7,500 in 2023 if they turn 50 years old by the end of the year.
There is a hitch, though. Employers may match your contribution with pretax dollars, and when 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 may pay taxes on this money—and on its earnings—once you start taking distributions.
Roth IRAs have a much lower contribution limit—$6,000 per year for 2022 and $6,500 for 2023. compared to a Roth 401(k). In addition, Roth IRAs are self-funded and do not allow for matching employer contributions.
Unlike Roth IRAs, Roth 401(k)s have no income limit, allowing high-wage earners to contribute to one.
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.
With a Roth IRA, 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 a Roth IRA’s earnings, for which preretirement withdrawals (if you’re under age 59½) still 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 less than five years, and free of penalty and taxes if you have held it for more than five years.
A third advantage of a Roth 401(k) account is the ability to borrow money against your account balance. 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.
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 another Roth IRA in that time frame, you are effectively getting a 0% interest loan for 60 days.
Roth IRAs vs. Roth 401(k)s (2023 information)
Only those making less than $153,000 can contribute ($228,000 for married couples).
Contribute up to $6,500 per year ($7,500 if older than 50).
No required distributions.
Wide range of investment options.
You can withdraw contributions freely, but earnings are taxed at 10% if withdrawn before age 59½.
You cannot borrow money from your balance, unless you execute a rollover.
Anyone can contribute.
Contribute up to $22,500 each year ($30,000 for those over age 50).
You must start taking distributions at age 72.
Only a few investment funds.
10% penalty on withdrawals before age 59½.
You can borrow up to 50% or $50,000 from your account balance, whichever is smaller.
Can I Take a Loan From My Roth IRA?
Technically, no. There is no provision for borrowing against your Roth individual retirement account (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—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 Roth types at the same time. The contribution limit for each is different: $22,500 for a Roth 401(k) and $6,500 for a Roth IRA in 2023. Both account types have catch-up contributions for people over age 50: an additional $5,500 for a Roth 401(k), and an additional $1,000 for a Roth IRA in 2023.
Can I Choose the 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. For many, it may help you at some point to switch between them to capitalize on the benefits of both.