Roth 401(k) vs. Roth IRA: Is One Better?
In the last few years, a new vehicle has been gaining ground on the retirement scene: the Roth 401(k). Back in 2007 (a year after they were created), only 11% of employers allowed their employees to make Roth contributions to their retirement plans; in eight short years, the number rose to 58%, according to Aon Hewitt’s 2015 Trends & Experience in Defined Contribution Plans.
But are they better than a Roth IRA? 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 factors you should use to compare them.
Not everyone is able to participate in a Roth IRA. Per the IRS, individual taxpayers who make $133,000 or more or married couples filing jointly who make $196,000 or more are not eligible to make Roth IRA contributions in 2017. To determine if you qualify, check out this Roth IRA calculator.
However, there are no income caps on Roth 401(k)s, making them, in this regard, a better option for people earning high incomes.
For 2017, you can contribute up to $18,000/year to your Roth 401(k), as well as an additional $6,000 if you'll turn 50 by the end of the year. That number is much lower for Roth IRAs, which limit you to $5,500 a year or $6,500 if you're 50 or older.
Here, the Roth 401(k) is the clear winner. However, if you reach the yearly cap for one type of account, you can always open the other type to effectively raise your overall contribution limit. For example, if you have both a Roth IRA and Roth 401(k) – and you're eligible to make contributions to both – your annual contribution maximum effectively becomes $23,500 (or $30,500 if you're 50 or older).
Required Minimum Distributions
This round goes to the Roth IRA. The Roth IRA doesn't require required minimum distributions (RMD) – ever.
That flexible feature gives you the option to keep contributing to your account and letting those funds grow indefinitely, which is beneficial if you don't need them 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 want to 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, N.J.
With the Roth 401(k), you can hold off these RMDs post age 70½ only if you're still working and 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.
While employers can help you set up and deduct money for traditional and Roth IRAs (see Roth vs. Traditional IRA: Which Is Right For You?), they are unable to make matching contributions to them. (Note: Employers can match contributions under a SIMPLE IRA; see Benefits of a SIMPLE IRA.)
Employers can match your contributions to a Roth 401(k) – they're actually offered a tax incentive to do so. But keep in mind that those matching funds and their earnings will be placed in a pre-tax account and taxed once you start taking distributions.
So, the Roth 401(k) wins this round as the better option.
Borrowing Against Your Account
With a Roth 401(k), 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 if you're under 59½ years old.
Roth IRAs don't technically allow loans, but there's 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 another Roth IRA in that time frame, you're effectively getting a 0% interest loan for 60 days. However, if you don't pay back the money you borrow, and you're under 59½ and not using the money for a qualified distribution, then you'll have to pay the 10% penalty. (For more on penalties, see Traditional and Roth IRAs: Which is Better for Taxes?)
Since you're essentially borrowing against yourself in both circumstances, neither the Roth 401(k) or Roth IRA has a particularly strong case for being a loan option.
The Bottom Line
There's no blanket, one-size-fits-all answer to the question "Which is better – a Roth IRA or a Roth 401(k)s?" Each has its own unique perks and benefits.
Long story short, a Roth 401(k) tends to be better if you're a high-income earner. It also allows you to have a Roth while getting the benefit of employer matching funds. But if you're looking for more flexibility in your use of retirement funds, the Roth IRA wins the competition.