Who is this for? Anyone that hopes to one day retire would benefit from understanding the difference between Roth 401ks and Roth IRAs, and how to navigate them both to your greatest advantage.
Maybe you’re here because you just started a new job and your employer offers a Roth 401(k) option. Perhaps you’re self-employed and are looking into starting your own Roth IRA. Or maybe you’re in the tech industry and keep hearing about the mega backdoor Roth 401(k).
Whatever reason you’re reading this, it’s always a good idea to plan for the future. When you hear people use terms like “traditional,” “after-tax,” “pre-tax,” and “Roth,” it’s easy to get lost and feel like it’s complicated. The reality is, it’s not that complicated once you get the terminology down and understand how each option works.
It does get a bit more complicated when you start analyzing your unique situation and goals and try to choose the best financial plan. The good news is there are plenty of professionals that can walk you through that, and help you make needed adjustments with your Roth 401(k) and Roth IRA decisions, and beyond.
In this article, we’re going to break down Roth 401(k)s, Roth IRAs, and everything related. When you’re finished, you’ll have the information you need to be an informed participant when designing your retirement plan with your financial advisor.
Let’s start with the word “Roth.” The word Roth originates from Senator William Roth of Delaware. In 1989 Senator Roth teamed up with Senator Bob Packwood of Oregon. They proposed the “IRA Plus Plan” which allowed individuals to invest up to $2,000 with no tax deductions. The earnings could be later withdrawn tax-free at retirement.
The Roth IRA was eventually established by the Taxpayer Relief Act of 1997 and named after Senator Roth. In 2000, 46.3 million taxpayers held IRA accounts amounting to $2.6 trillion. Only about $77 billion was held in Roth IRAs. Seven years later the number of IRA owners jumped to 50 million with $3.3 trillion invested.
As we discovered above the Roth IRA came into existence in 1997. The Roth 401(k) was first available in 2001. A Roth 401(k) has higher contribution limits, and lets employers match contributions. A Roth IRA offers more investment options, and allows for easier early withdrawals.
A Roth 401(k) account is set up by your employer for your retirement. There are no AGI (adjusted gross income) limits to contribute like there are with Roth IRAs. However, there are contribution limits. The maximum you can contribute is $19,500. If you’re older than 50 the limit is $26,500. The contribution limit counts towards both your Traditional and Roth 401(k). This means the combined total can’t be more than $19,500.
Roth IRAs are set up by individuals for their retirement. Employers have nothing to do with Roth IRAs, unlike Roth 401(k)s. Individuals can only contribute to a Roth IRA if their Adjusted Gross Income (AGI) is under $196,000 - $206,000. The IRS offers a phase-out table for more information. If you’re eligible for a Roth IRA, your maximum contribution is $6,000. It’s $7,000 if you are over 50.
Roth 401(k) plans are subject to required minimum distributions. Roth IRAs are exempt. The IRS requires Roth 401(k) holders to take mandatory distributions from their account starting at age 72. The withdrawals are based on your remaining life expectancy. Roth IRAs allow you to leave your money in the account and let it continue to grow until death.
Since many individuals are not able to contribute to a Roth IRA due to the AGI phaseout explained above, an alternative strategy is the “Backdoor” Roth IRA. In this scenario an individual contributes to a traditional IRA (this likely would be a non-deductible or after-tax contribution for most people) and subsequently, and preferable immediately, converts their contribution to a Roth IRA.
Some important notes about the conversion – 1. the conversion of the contribution is not taxable if the contribution was considered after-tax and non-deductible; 2. Any growth in the contribution would be taxable at the point of conversion (therefore it makes sense to convert immediately after contribution); and 3. All IRA accounts are taken into account when determining the portion of the conversion that is taxable (so this strategy makes the most sense for people that have no other IRA’s).
So far we’ve been talking a lot about Roth, but what about the traditional 401(k)? The main difference between a Roth 401(k) and a traditional 401(k) comes down to taxes. When you fund a traditional 401(k), whatever you put into it has not been taxed (pretax income). With a Roth 401(k) whatever you put in has already been taxed.
When you’re ready to take money out of your traditional 401(k) that money will be taxed. When you take money out of your Roth 401(k) that money will not be taxed. Ultimately contributions to both are taxed, the difference is when they are taxed.
One important note about traditional 401(k)s is the Maximize Me Always option. Many plans have an option to always have your contributions maximized automatically. If you turn this option on, then when your salary increases, your max contribution will be adjusted for you automatically. This is a nice set and forget option to have turned on within your plan if your goal is to maximize your contributions.
A mega backdoor Roth is a technique that allows high earners, like those in the tech industry, a way to contribute more to their Roth 401(k).
Three things matter when it comes to Mega Backdoor Roth 401(k)s.
Some plans allow you to make an in-service withdrawal from your 401(k) plan to an IRA account, at the time of an in-plan conversion. The benefit of this is it allows you to self-manage the account via an IRA. Disadvantage may exist such as potentially higher expenses in an IRA and loss of creditor protection.
You know you can put in $19,500 if under age 50, or $26,500 if over age 50 into a Roth 401(k) or traditional 401(k), or even split it between the two. However - your pretax contribution cannot exceed those amounts.
So what about your company match? How does that factor in?
If you are an Apple employee, for example, you may earn $200,000 annually. If Apple matches 6%, you’re getting an additional $12,000 to add to your $19,500 - so now you have $31,500 (if you’re under age 50).
But you’re still not maxed out!
The IRS’s 15C limit says that in 2020, anybody can put up to $57,000 into a 401(k). So after $31,500, you still have $25,500 of space left. How do you get that extra amount in?
Some companies convert it automatically for you. Some companies make you select a button to initiate the automated conversion. And other companies make you manually convert it by either calling the 401(k) administrator or, in the case of Apple, submitting a paper form, or uploading a paper form to the website. It can take some time to set it up correctly.
Some companies, like Google and Facebook, allow employees to take the deferral on their bonus compensation. For example, an employee who gets a $50,000 annual bonus can choose to have 100% of the bonus (up to the max) go into their additional after-tax 401(k) and then convert it to the Roth. This helps keep cash flow more constant throughout the year.
The mega backdoor Roth 401(k) is a good tool for those who are looking to save additional amounts for retirement. This is a great strategy for high-income earners that have maxed out other tax-deferred saving vehicles and are looking to save more and maximize their benefits.
Although a Roth 401(k) account is funded with after-tax dollars, it is not immune to taxes and penalties. Understanding the rules regarding withdrawals is important if you want to avoid losing part of your retirement savings. Contributions and earnings in a Roth 401(k) can be withdrawn without paying taxes and penalties if you’re at least 59 and a half years old and you meet the five year rule. Other exceptions include being permanently and totally disabled. You can also use up to $10,000 for a first-time home purchase without penalty or taxation.
All withdrawals are not the same. Your Roth IRA contribution can be used in an emergency. If you need to take an early withdrawal from a Roth account contributions come out first. This is a nice move by the IRS to make things easier for you. When you’re just tapping into your contributions, you don’t have to worry about taxes, unless you pull out more than you’ve contributed.
Things get more complicated when you start tapping into earnings. You can be taxed and have to pay a 10% penalty for early withdrawals on your Roth account earnings. However, there are some circumstances where you will not have to pay the 10% penalty, but still need to pay taxes. These special circumstances include:
Rolling over your Roth 401(k) into a Roth IRA can be beneficial because of greater investment flexibility with an IRA. Typically, individual IRA accounts have wider investment options than Roth 401(k). Sometimes your options in a 401(k) are limited to mutual funds or a few different index funds.
One thing to keep in mind is the 5-year rule. If you roll a Roth 401(k) to a Roth IRA, it’s the time clock on the Roth IRA that counts. For example, imagine you’ve had a Roth 401(k) for 10 years and a Roth IRA for five years. If you roll your Roth 401(k) to that Roth IRA the clock is reset to the time you’ve had the Roth IRA. In this case, it’s five years, so you’re good. If that Roth IRA was only active for three years, then you’d need to wait two more years before you could withdraw earnings tax-free.
What do you do after you’ve maxed out your traditional 401(k)? If your employer offers a Roth 401(k) then you could consider using it to set aside some post-tax retirement savings. Unlike Roth IRAs, both 401(k)s and Roth 401(k)s don’t have income phase-out limits. So if you don’t qualify for a Roth IRA because your income is above IRS income limits you can make after taxes contributions to a Roth 401(k).
Yes, current law allows you to have both. You can have a 401(k) plan with a Roth 401(k) provision and still fund a Roth IRA. You are free to do that as long as your income does not exceed the limits of making a Roth IRA contribution. That limit is $196,000 - $206,000.
In many cases, it’s an advantage to have both a Roth 401k and a Roth IRA. Your Roth 401(k) will allow for high contribution limits. This enables you to save more. When you pair that with a Roth IRA you open up wider investment options. You can make the best of the investment selections offered within your 401(k) plan, then expand your investing through your Roth IRA to access any investment you like.
If your company offers a 401(k) match, it will be made into the traditional pre-tax bucket. If you contribute to a Roth 401(k) the funds will still be matched by your employer, but not into the Roth bucket.
The rule of thumb for retirement savings starts at 10% for most. But, every person’s situation is different, and retirement goals, existing resources, lifestyle, and family all need to be accounted for. No matter what your situation is, it’s recommended that if your company offers a 401(k) matching contribution, you should put in at least enough to get the maximum amount. Typical matches are 3%. Always take advantage of a company match because it’s basically free money.
Once you leave your job with an employer you have four options about what to do with your Roth 401(k) plan.
A lot of people are hesitant to begin a Roth 401(k) because they are worried about how it will affect their take-home pay. At a minimum, it’s always recommended to contribute up to your employer’s match even if you are focused on getting out of debt or saving for a new home. This is essentially free money.
There is no getting around that your contributions will directly affect your take-home pay. The contributions are made with after-tax dollars. But remember, the future earnings in your Roth 401(k) are not taxable. This can end up paying off big time once you hit retirement.
When you want to retire is the biggest factor that determines how much money you need in your 401(k). The average retirement age for most people is some time in their 60s or 70s.
Some general guidelines are as follows. By the time you’re 30, you should have saved half of your annual salary. So if you’re earning $50,000 by age 30, you should have $25,000 in retirement savings. By age 40, you should have saved twice your annual salary. By age 50, it goes up to four times. Age 60, six times. If you reach 67 and are earning $75,000 per year, you should have $600,000 saved.
By now you should have a good understanding of Roth 401(k)s and Roth IRAs. Below is a quick reference for some of the most frequently asked questions about both. More in-depth explanations can be found in the main body of this article above.
There is no age limit. You can contribute to your Roth IRA until death if you choose to.
Yes, a Roth IRA is a vehicle that holds investments. If your investments lose value you will lose money.
Theoretically no. Your total contribution would be divided between both, so neither one would technically be maxed out. Aggregate (combine) contributions to 401(k) and Roth 401(k) are capped at $19,500 ($26,500 if over 50).
That depends on your retirement goals. A good financial plan will lay that out for you.
All contributions can be withdrawn tax and penalty-free. Earnings, however, will be taxed and penalized if you have not met the five-year rule and they are not used for a qualified exception.
You are free to take any contributions out of your Roth 401(k) without penalty at any time. Only earnings will be subject to penalty.
Anyone who works for an employer that offers a 401(k) to their employees qualifies for a 401(k).
Both Roth 401(k)s and Roth IRAs are great tools for your retirement strategy. Each one comes with advantages and disadvantages, and together they are very powerful.
Open Advisors specializes in financial planning for tech employees and young families. If you are thinking about optimizing your retirement strategy but need a little guidance we can help. If your company offers a 401(k) or a Roth 401(k) you’re in a great position to start accumulating wealth for retirement.
We can help you make a plan that gives you the freedom to enjoy today while persuing your future comfort and stability for your retirement years.