Roth 401k vs Roth IRA

Roth 401(k) vs Roth IRA: What’s The Difference?

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Have you decided that choosing a Roth retirement account to have tax-free growth is a good option for you? It can be for many professionals! But you’ve heard all kinds of words floating around with the word “Roth” attached. There’s a Roth IRA, and now there’s also a Roth 401(k). What’s the difference? Can you have both? How do you choose? We will answer those questions and many more in this blog. Let’s get right into comparing Roth 401(k) vs Roth IRA.

What is a Roth 401(k)?

A Roth 401(k) is a type of employer-sponsored retirement account. Many employers offer company 401(k)s that allow employees to defer some of their income into the account to save for retirement. Many employers also match those contributions up to a percentage or flat dollar amount. Many employers are now adding the option for the employee contributions to be Roth or traditional, or a mixture of both. It is up to the employee to choose how they want to save their money.

If you choose to contribute to your Roth 401(k), your money will be taxed now and grow tax-free. If your employer matches or makes a flat contribution to your 401(k), the employer funds will be traditional because no income tax has been paid on them yet. So you will have both a traditional 401(k) holding employer contributions and Roth 401(k) holding your contributions. This can actually work out in your favor in retirement because you will have the option for strategic tax planning surrounding those withdrawals, allowing you to pay less tax in retirement than you otherwise would if you only had traditional funds to use.

If you work for a company that offers a 401(k), check to see if they allow Roth contributions.

What is a Roth IRA?

A Roth IRA is a type of Individual Retirement Account in which post-tax money is added to the account directly by the account owner (as opposed to being deducted from the paycheck and added to the account as is the case with a 401(k)).

For example, if your paycheck hits your bank account on the 1st of the month, the money that you got has already been taxed and had all the employer deductions taken out. You can then take some of that money from your bank account and transfer it into a Roth IRA that you can open with a financial institution. There are income limits and contribution limits for Roth IRAs, which we will discuss in detail below.

Now that you know the basics, we will explore the similarities and differences between Roth IRA and Roth 401(k)s.

Want to know if you can make a Backdoor Roth IRA contribution? Find out here!

Roth 401(k) and Roth IRA Income Limits 2024

Roth IRAs have income limits. If you make too much money, you are not eligible to contribute to a Roth IRA. Those limits for 2024 are $161,000 Modified Adjusted Gross Income (MAGI) for single filers and $240,000 MAGI for Married Filing Jointly.

Roth 401(k)s do not have income limits. Regardless of how much you make, if your company offers a Roth 401(k) option, you can participate. This difference allows higher-income earners to have tax-free retirement savings they might not otherwise have had.

Roth IRA vs Roth 401(k) Contribution Limits 2024

For 2024, a Roth IRA has a maximum yearly contribution limit of $7,000 and an additional $1,000 catch-up contribution ($8,000 total) if you’re aged 50 and older.

The Roth 401(k) contribution limit is $23,000 with an additional $7,500 catch-up contribution ($30,500 total) if you’re over age 50. This is an obvious and huge benefit to a Roth 401(k). Prior to 2001, Roth 401(k)s did not exist. The maximum amount anyone could put into a Roth account was the yearly maximum for Roth IRAs.

Required Minimum Distributions (RMDs)

A required Minimum Distribution is a requirement by the IRS to begin withdrawing from retirement accounts at a specified age. There are multiple rules surrounding this. The main rule is if you are age 70.5 or 72 (depending on your birth year) then you must begin taking minimum distributions from retirement accounts each year, whether you need the money or not. This rule was put in place because traditional retirement accounts grow tax-deferred, meaning no tax has been paid on the contributions or earnings. The IRS has allowed you to defer taxes for all of those working years, and they are now ready for their cut of that money.

Now of course, with a Roth account, the IRS won’t get a cut when you withdraw. As we know, with Roth accounts, you put your money in after you have paid income taxes and then you get to take all of the contributions AND earnings out tax-free in retirement. Unfortunately, that doesn’t mean you get to escape those pesky RMDs though. This is another main difference between Roth 401(k) and Roth IRAs.

Roth IRAs do not have RMDs.

You can leave this money growing tax-free for as long as you wish.

Roth 401(k)s do have RMDs but in 2024 they will no longer be required.

Even though this money is Roth and the IRS won’t get any additional taxes out of it, you still have to begin taking distributions. However, starting in 2024, RMDs will no longer be required. 

Early Withdrawals

Another difference between a Roth 401(k) and Roth IRA is how early withdrawals from these accounts are treated.

Early Roth 401(k) withdrawals:

If your employer allows for in-service withdrawals (a withdrawal while still employed with the company), you can access your contributions tax and penalty-free, since they are made with money that has already been taxed. If you take the earnings out though, you may have to pay income tax as well as a 10% penalty. The problem with taking money from a Roth 401(k) before you meet the qualified distribution rules is that early withdrawals are pro-rated and will be considered partially your contributions and partially your earnings. You can’t choose to just take out earnings. It can get messy.

Early withdrawals from a Roth IRA:

With a Roth IRA, you are allowed to take out only your contributions anytime with no penalty and no tax. The earnings can stay in the account and continue to grow.

Here is an example: Let’s say you have $10,000 in a Roth IRA and $10,000 in a Roth 401(k). We will assume that you contributed $6,000 to each of these accounts and $4,000 in each of these accounts is market growth. You decided one day that you would like to use $6,000 of your retirement money to go on a dream vacation. Or maybe life just got expensive and you need some extra funds that year. Which account should you withdraw from?

With that Roth IRA, if you take out $6,000, you will not pay any tax or penalty on that money because all $6,000 is considered a return of contributions, which you already paid tax on.

With the Roth 401(k), if you take $6,000 out, you will pay some tax and penalty because of the pro-rata rule. They will take the total $10,000 and figure out what percentage of that total account balance was contributions, in this case, 60%, and how much was growth, in this case, 40%. If you take $6,000 out early, 60% will come out as a tax-free return of contributions, and 40% will be considered an early withdrawal of growth. You will pay potential income tax and a 10% penalty on $2,400 of your early withdrawal.


M
atching contributions

Roth IRAs do not have employer matching. Roth 401(k)s do have employee matching. The employee’s contributions can be matched by the employer up to a certain percentage. This is essentially free money from the employer.

Previously, the employer’s contributions were placed into a traditional 401(k) rather than a Roth 401(k). However, after the SECURE Act 2.0 passed, employer contributions can now be placed into a Roth 401(k). This is still optional meaning that it is up to your employer if they want to do a match, and if they want to place that money into a traditional or Roth 401(k).

Can I transfer my Roth 401(k) to a Roth IRA?

Generally, once you leave the employer, you can transfer your Roth 401(k) into a Roth IRA. You will need to be careful not to inadvertently move any pre-tax (traditional) money that’s in your 401(k) into a Roth IRA because this would trigger a taxable event. If you wanted to avoid any additional tax, but you decide to move all of the money out of the 401(k) is the best decision, you would need to move traditional money into a traditional IRA. Then the Roth money would go into a Roth IRA to keep the same tax treatment in place.

Can I contribute to a Roth IRA and a Roth 401(k)?

In short, yes. If you are eligible to contribute to a Roth IRA (remember the income cap), and your employer offers a Roth option in your 401(k), you can contribute the full contribution limit into the Roth IRA and the full contribution limit into your Roth 401(k). 

Should I open a Roth IRA if I have a Roth 401(k)?

If you have the funds to do so and your income allows Roth IRA contributions, you can grow your retirement savings faster by contributing to both! More money into retirement funds is a great idea, and often more money into Roth is an even better one. However, we do recommend you consult your fiduciary financial advisor to make sure your income limits aren’t in excess of the limits for a Roth IRA, and that contributions to a Roth IRA and Roth 401(k) fit within your financial plan and goals.

What should I do if I have to choose between a Roth 401(k) or a Roth IRA?

If your finances put you in a position where you have to choose between a Roth 401(k) and a Roth IRA:

A Roth 401k might be better for you if: Your employer plan allows Roth contributions and you want to put away more than $7,000 of Roth money towards retirement each year. In addition, if your income puts you over the Roth IRA contribution limits, this allows you to still contribute Roth money towards retirement.

A Roth IRA might be better for you if: You qualify for Roth IRA contributions and you want the flexibility that comes with a Roth IRA account (easy tax-free withdrawals of contributions). If you already get your employer match and can still put funds towards retirement, maxing out your Roth IRA each year is a great idea.

Another consideration is the type of investments available to you. With a Roth 401(k), your investments are limited to the ones available in your 401(k) plan. It can be great, or it can be sub-par. With a Roth IRA, you have control over the funds you can invest in. But a powerful tool can be a double-edged sword, and it’s best to consult a financial planner when making investment decisions.

Roth 401(k) vs Roth IRA: Pros and Cons

AccountProsCons
Roth 401(k)- Higher contribution limits
- No income limits for eligibility.
- Employers often match a portion of contributions
- Not all employers offer Roth 401(k)s.
- Required minimum distributions (RMDs) at age 72 or 73 until 2024.
- A limited selection of investment options
- You need an employer to open one.
Roth IRA- You can open one even if you don't have access to a workplace retirement plan.
- Broad range of investment options
- No withdrawal requirements
- Low contribution limits
- No employer matching contribution
- High earners can't contribute

Consider a Roth 401(k) or a Roth IRA for your retirement. 

Both are great ways to save for retirement, and each has its pros and cons. If you need help deciding, or just want to talk to someone about getting your finances on the path towards financial freedom, schedule a free discovery call with one of our certified financial planners today.

Bonus: Does your income put you above contribution limits for a Roth IRA? Check out our video on the Backdoor Roth IRA technique.

Best Financial Planner Washington DC

Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.

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District Capital is an independent, fee-only financial planning firm. We help professionals and entrepreneurs in their 30s and 40s elevate their finances and maximize their money. We are based in Washington, D.C and we work with people virtually nationwide.

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