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Roth 401(k), Roth IRA . . . What's the Difference?

If you do any amount of research online, you'll find financial advisors everywhere touting the benefits of the Roth retirement account. However, what is often less discussed are the differences between the Roth IRA and the Roth 401(k). What exactly are the differences, and how does this impact your retirement savings? There are pros and cons to each and they're not as similar as you might think.

How are they similar?

For the most part, their similarities begin and end at the means in which the accounts help you save for retirement. The way that the Roth account works, is that it allows you to put money away in an account on an after-tax basis (money that has already been subject to income tax). Once the money is in the account, it continues to grow tax-deferred, and can be withdrawn tax-free in retirement. Financial advisors love these accounts because the younger you are, the more time the money has to grow tax-free. It also gives retirees tax diversification. Ideally a person in retirement will have a mix of accounts with different tax attributes allowing them to better manage their tax liability in retirement. While we may all appreciate the tax-free nature of these accounts, there are many differences that can make one account more feasible than the other. 

Roth IRA:

Often when people think of a Roth account, they think of the IRA version. The Roth IRA came about in 1997 thanks to the Taxpayer Relief Act of 1997and has been around ever since. Who is eligible to participate in a Roth IRA, and what are the rules surrounding it? We'll take a closer look at those below.

1) Who can contribute?

There are two main tests to determine if you are eligible to contribute to a Roth IRA. The first is income. For 2019 a taxpayer's AGI (adjusted gross income) must be less than $122,000 if filing Single and $193,000 if Married Filing Jointly. Between $122,000 - $137,000 for Single and $193,000 - $203,000 for Joint the contribution amount phases out until it is disallowed entirely. What this means is that a taxpayer can contribute less and less of the maximum amount the higher their AGI is. 

The other test is that you also have to have earned income. This means you need to earn money from some sort of work, (either being self-employed or from an employer). If your only income is from investments, or Social Security, this does not qualify for the earned income test. Note: Spouses who do not work or have enough earned income of their own, can count their spouses income as their own to qualify to contribute to a Roth IRA. 

2) How much can you contribute?

For 2019 you are allowed to contribute $6,000 a year. If you are over the age of 50, there is a catch up contribution of $1,000, which totals to $7,000 annually.3

3) How long can you contribute?

There is no age limitation so long as you still meet the qualifications from item 1 above. As long as your AGI is low enough, and you still have earned income you are able to contribute to a Roth IRA.

4) When can you withdraw money?

For a Roth IRA, you can withdraw your contributions any time free of penalty. For any earnings on the account, those can be withdrawn penalty free after you reach the age of 59.5 and have had the account for five years. Between your current age and 59.5, if any of the earnings are withdrawn (the amount the account has grown above what you contributed) those will be subject to income tax and a 10% early withdrawal penalty unless an exception applies. As financial advisors we urge our clients not to make withdrawals at all while they're working (so that it can continue to grow tax-free!), but if an emergency arises where money is needed, not to withdraw more than the contributions they put in to avoid this penalty.  

Roth 401(k):

While the Roth IRA and Roth 401(k) share the same tax-free nature, there are many differences when it comes to eligibility and withdrawal rules. The IRS calls Roth 401(k)s "Designated Roth Accounts". Note: These rules and recommendations also apply to the Roth 403(b) and Roth Thrift Savings Plan.  

1) Who can contribute?

The great part of a Roth 401(k) is that there is no income limitation associated with contribution eligibility. Even the highest corporate executive with pay well above the AGI limits of a Roth IRA can still contribute to a Roth 401(k). The caveat to this, however, is that your company has to offer a Roth 401(k) option. If your company currently offers a 401(k) but not a Roth feature, it's not a bad idea to suggest to your HR department that they look into adding it to your 401(k) plan as well. 

2) How much can you contribute?

This is where the Roth 401(k) stands out in comparison to the Roth IRA. The maximum contribution limits are the same as the total 401(k) contribution limits for 2019. This is  $19,000 with a $6,000 catch up for those age 50 and older.Keep in mind that these contribution limits apply to contributions to both the Traditional 401(k) and Roth in total. You cannot contribute $19,000 to your traditional 401(k) and $19,000 to the Roth. The combined contributions to both must be at, or below, the maximum contribution. 

3) How long can you contribute?

Since a 401(k) plan is tied to your employer, you are eligible to contribute as long as you are working for your employer and they continue offering this retirement plan. 

4) When can you withdraw money?

How you can withdraw money out of your Roth 401(k) depends on your employer. Some employers only let you take a distribution as a lump sum (take it all, or leave it all). Others limit the number of withdrawals you can take over the course of the year. Some may have no restrictions at all, and you can withdraw as little or as much as you want. The tax implications of withdrawals from a Roth 401(k) are the same as a Roth IRA. 

The big downside to the Roth 401(k) is that Required Minimum Distributions (RMDs) are mandatory. For those not familiar with RMDs, this is when you are required to take a bare minimum out of certain retirement accounts (of course you can always take more). Roth IRAs are excluded from this, but Roth 401(k)s are not. Currently, the age where these distributions begin is the year in which you turn 70.5, (however proposed legislation is considering increasing that to age 72).  An exception to RMDs is that as long as you are still working for the employer, you are not required to take distributions yet. 

The Verdict:

Both the Roth IRA and 401(k) are great retirement savings tools. However, their effectiveness and eligibility will differ from one person to the next. If you are eligible to contribute to a Traditional and Roth 401(k) how much to put into each will vary greatly depending on your tax situation. For answers to there complex tax planning questions you should reach out to your financial planner or tax advisor. 

Roth IRA 
AGI and earned income 
requirement 
$6,000 contribution limitation 
($1,000 catch up over age 50) 
No age-cap on contributions 
Withdraw penalty free after age 
59.5 
Tax-deferred 
growth and 
tax-free 
eligible 
withdrawals 
Roth 401(k) 
No AGI limitation. Employer 
must offer plan 
$19,000 contribution limit 
($6,000 catch-up after age 50) 
Can contribute as long as your 
employer offers the plan 
Withdrawal varies by plan. 
Potential penalty- free 
withdrawals after age 55. 
RMDs are mandatory

1 https://www.investopedia.com/terms/r/rothira.asp

2 https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2019

3 https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits

4 https://www.irs.gov/newsroom/401k-contribution-limit-increases-to-19000-for-2019-ira-limit-increases-to-6000