Roth IRA vs. Roth 401(k)
The Roth IRA, established by the Taxpayer Relief Act of 1997, offered a new twist to the traditional IRA — namely, after-tax contributions. What this means is that a Roth IRA owner may contribute money up to the limit each year with income that has already been taxed. The account’s earnings grow tax free, and when the owner reaches retirement and is ready to withdraw income, he or she will not owe taxes on qualified distributions.1
The Roth IRA was a bit groundbreaking at the time because it introduced the idea of “tax diversification” into retirement plans. In other words, if “qualified” retirement plans (those in which an employer contributes, such as 401(k) plans) defer taxes until withdrawn, retirees may end up with a sizable tax obligation when they start drawing income from the plan. By diversifying income contributions between the Roth and qualified retirement accounts, not all of this retirement income would be taxable. Thus, it made sense for many individuals to contribute to two different types of retirement accounts — even if they were both IRAs (traditional and Roth).2
However, things got more complicated in 2006. That’s when the “designated Roth account” program went into effect, permitting employer-sponsored 401(k), 403(b) and 457(b) plans to include a Roth investment option. This can be confusing, because every other investment option in qualified plans accepts only tax-deferred contributions, to be taxed once distributed in retirement. The new rule allowed already-taxed Roth contributions to be included as an option in employer-sponsored plans, along with options investing tax-deferred money. Managing both versions can add to employers’ administrative costs.3
Even though the designated Roth 401(k) option has been around since 2006, it remains widely misunderstood by employees. In a recent survey by Cerulli Associates, only one-third of some 1,000 Roth 401(k) plan participants surveyed understood the benefits of investing on an after-tax basis.4
The following is a primer to help clarify some of the finer points that differentiate the standalone Roth IRA from the designated Roth 401(k).
Income Limits to Open/Contribute to a Roth5
Roth IRA — Single filers and married couples filing jointly with a modified adjusted gross income greater than $135,000 or $199,000 (respectively) may not contribute.
Roth 401(k) — There are no income limits restricting contributions.
2018 Contribution Limit6
Roth IRA — $5,500; $6,500 if age 50 or over.
Roth 401(k) — $18,500; $24,500 if age 50 or over. Note: You can split your annual deferral between designated Roth contributions and traditional pre-tax contributions, but your combined contributions cannot exceed these limits.
Roth 401(k) — Employer contribution “matches” do not count toward the individual annual limit.7
When Income Is Taxed8
Roth IRA — Requires after-tax contributions; qualified distributions are tax free.
Roth 401(k) — Requires after-tax contributions; qualified distributions are tax free. If an employee receives an employer match on Roth 401(k) contributions, the employer match is a pre-tax contribution and the funds that result from employer matches and any associated growth will be taxed as ordinary income when withdrawn as a qualified distribution.
Required Minimum Distributions (RMDs)9
Roth IRA — Account owners do not have to take RMDs.
Roth 401(k) — Account owners must take RMDs starting at age 70 ½, unless they are still working and are not a 5% or more owner of the business sponsoring the plan.
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1 Investopedia. “Roth IRA.” https://www.investopedia.com/terms/r/rothira.asp. Accessed Dec. 14, 2017.
2 Robert Powell. USA Today. Nov. 4, 2017. “Many unaware of Roth 401(k) benefits.” https://www.usatoday.com/story/money/columnist/powell/2017/11/04/many-unaware-roth-401-k-benefits/797361001/. Accessed Dec. 8, 2017.
3 Denise Appleby. Investopedia. Nov. 30, 2015. “Roth 401(k), 403(b): Which Is Right for You?” https://www.investopedia.com/articles/retirement/06/addroths.asp. Accessed Dec. 14, 2017.
4 Robert Powell. USA Today. Nov. 4, 2017. “Many unaware of Roth 401(k) benefits.” https://www.usatoday.com/story/money/columnist/powell/2017/11/04/many-unaware-roth-401-k-benefits/797361001/. Accessed Dec. 8, 2017.
5 IRS. Nov. 3, 2017. “Roth Comparison Chart.” https://www.irs.gov/retirement-plans/roth-comparison-chart. Accessed Jan. 10, 2018.
7 Robert Powell. USA Today. Nov. 4, 2017. “Many unaware of Roth 401(k) benefits.” https://www.usatoday.com/story/money/columnist/powell/2017/11/04/many-unaware-roth-401-k-benefits/797361001/. Accessed Dec. 8, 2017.
8 IRS. Nov. 3, 2017. “Roth Comparison Chart.” https://www.irs.gov/retirement-plans/roth-comparison-chart. Accessed Jan. 10, 2018.
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