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Roth 401(k) vs Roth IRA

Retirement Planning

April 2, 2020

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.

What does Roth Mean? Where did the Term come from? Why is it called Roth? Is Roth an Acronym?

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 The earnings could be later withdrawn tax-free at retirement.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.

What is the Difference between a Roth 401(k) and a Roth IRA?

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.

What is a Roth 401(k)?

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 $26,000. The contribution limit counts towards both your Traditional and Roth 401(k). This means the combined total can’t be more than $19,500.

What is a Roth IRA?

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 70 and ½. 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.

What is a Back-Door Roth IRA?

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 Uno other IRA’s).

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What is the Difference between Roth 401(k) and a Regular 401(k)?

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.

Mega Backdoor Roth 401(k) - What is it and How does it Work?

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.

  1. The plan must have a Roth 401(k) component.
  2. The plan must allow an after-tax 401(k) contribution above the normal $19,500 and $26,500 max.
  3. The plan must allow for an in-plan conversion of after tax 401(k) contributions to your Roth 401(k).

Who Should Consider a Mega Backdoor Roth 401(k)?

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.

Roth 401(k) and Roth IRA Early Withdrawal

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. 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.

Early Withdrawal of Roth Account Contributions

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.

Early Withdrawal of Roth Account Earnings

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:
  • Qualified education expenses.
  • Medical expenses that exceed 7.5% of your adjusted gross income for the year.
  • Up to $5,000 withdraw in the year after the birth or adoption of your child.
  • Health insurance premiums while you are unemployed.
  • Qualified reservist distributions - members of the military reserve called to active duty.

Converting Roth 401(k) to Roth IRA

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.

The 5-Year Rule

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.

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Roth 401(k) vs Traditional 401(k) for High-Income Earners

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).

Can I Have Roth 401k and Roth IRA?

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.

Do Employers Match Roth 401(k)s?

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.

How Much Should I Put in my Roth 401(k)?

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.

WHAT HAPPENS TO MY ROTH 401(K) WHEN I QUIT?

Once you leave your job with an employer you have four options about what to do with your Roth 401(k) plan.

  • Maintain it The majority of Roth 401(k) plan sponsors allow you to keep your account with them after leaving your job. However, you no longer have the option to contribute directly to the plan. You are limited to the investment options the plan provides.
  • Transfer it In some cases you can transfer your Roth 401(k) to your new employer’s plan. This option is only possible if your new employer offers a Roth 401(k) plan that accepts transfers.
  • Roll it Over A rollover transitions your Roth 401(k) into an individually held Roth IRA through a tax-free transfer. You will gain more control over your investment choices and have the opportunity to contribute additional funds.
  • Cash it Out You can take a lump-sum cash distribution once you leave your job. There are tax implications if you are under 59 ½. You will also be tapping into your retirement fund early if you’re not of retirement age.

HOW DOES A ROTH 401(K) AFFECT MY PAYCHECK?

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.

HOW MUCH MONEY SHOULD YOU HAVE IN YOUR 401(K) WHEN YOU RETIRE?

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.

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ROTH 401(K) & ROTH IRA FAQS

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.

At what age should I stop contributing to my Roth IRA?

There is no age limit. You can contribute to your Roth IRA until death if you choose to.

Can you lose money in a Roth IRA?

Yes, a Roth IRA is a vehicle that holds investments. If your investments lose value you will lose money.

Can I max out my 401(k) and Roth 401(k)?

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 ($26,000 if over 50).

How much should I put in my Roth IRA monthly?

That depends on your retirement goals. A good financial plan will lay that out for you.

How can I withdraw from my Roth IRA without penalty?

All contributions can be withdrawn tax and penalty-free. Earnings, however, will be taxed and penalized depending on what you will use the funds for.

When can I take money out of my Roth 401(k) without penalty?

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.

Who qualifies for Roth 401(k)?

Anyone who works for an employer that offers a 401(k) to their employees qualifies for a 401(k).

Conclusion

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 securing your future comfort and stability for your retirement years.