Roth IRA & Roth 401(k): Similarities & Differences

I’ve been asked about the similarities and differences between these two accounts a lot lately — in bars, at social events, even over text. And I understand that people find them confusing because both have the term ‘Roth’ in the title. Admittedly, there are quite a few similarities. So, let’s tackle those first.

Similarities:

1. Both the Roth IRA and Roth 401(k) are compiled from post-tax money. This means that the IRS has already taxed the money you’re putting into either account.
2. Both accounts grow tax free. If you have a lot of dividend paying stocks, REITs, Bonds, Index Funds, or Mutual Funds, then those dividends also accumulate and grow tax free!
3. You can also qualify to receive the income from both accounts in retirement tax -free. In order to qualify for tax-free income in retirement, distributions cannot be taken before you reach age 59 ½. In addition, you must be participating in a Roth plan for a minimum of five years at the time distributions are taken. As long as you meet those two criteria, the distributions you receive from the plan will be tax-free.
4. Another unique feature of Roth accounts: You can withdraw your contributions from a Roth plan at any time, without having to pay either ordinary income tax or the 10% early withdrawal penalty on the distributions. There are, however, some rules around this. Very simply, it breaks down like this: you can take principle money from the account, but it has to be claimed on your taxes as a principle withdrawal. Sometime, in the case of the 401(k) you may have to do it as a loan or hardship withdrawal. You should absolutely ready the IRS guidelines for both accounts. Please note that not all Roth 401(k) plans allow for early withdrawals, though. It really is case dependent for the Roth 401(k), but this still looks like a similarity.
5. The final similarity. Distributions from either will not influence your Social Security tax rate. Currently, Social Security income is taxable based upon a two-tiered structure. Keeping you in the lowest bracket is certainly a win because you keep more of your money. This could potentially save you hundred or even thousands of dollars in taxes during retirement!

Differences:

1. The biggest and most obvious difference is the contribution limit of Roth IRAs versus Roth 401(k)s. The Roth IRA limit for 2019 is $6,000, with the catch-up contribution limit of $7,000 for those 50 and over. The Roth 401(k) limit is $19,000, with the catch-up contribution limit of $25,000 for those 50 and over.
2. The Roth IRA also has a phaseout income limit. This means that if your modified adjusted gross income is over a certain threshold, you cannot contribute to a Roth IRA. The modified adjusted gross income for singles must be under $137,000; contributions are reduced starting at $122,000. For married filing jointly, the MAGI is less than $203,000, with phaseout starting at $193,000.
3. The Roth 401(k) has no income phaseout limits.So, if you’re making above the Roth IRA threshold, then contributing to the Roth 401(k) becomes the best way to put away a huge chunk of money for a tax-free retirment.
4. There is potentially employer matching in a Roth 401(k). There is no match in a Roth IRA because it is a self-funded account. At the end of the day, you should always contribute up to your employer’s match — it’s free money! They will, however, put it in a traditional 401(k) account because of taxation rules.
5. Roth 401(k) has a Required Minimum Distribution (RMD) rule that begins at 70 ½. If you miss that distribution, there are penalties. The Roth IRA doesn’t have an RMD, which allows you to keep the money growing for your entire life. You could even pass the money to a future generation.
6. Investment Choices: The Roth 401(k) investment choices are set up by your employer. Some employers do a phenomenal job in giving their employees a broad range of choices and low fees — other employers fall short. Roth IRAs, however, are self-directed accounts. That means you get to choose what you buy, when you buy or sell, and how much. There’s a lot more freedom in using a Roth IRA.
7. The final difference is that you cannot borrow money from a Roth IRA because it’s a self-directed account. You can, however, borrow from a Roth 401(k) if it is set up as a provision within your company’s plan. The best way to find out is to ask someone in HR, or read that stack of paper they sent you when you started the account. Some other rules: The IRS will let you borrow up to 50% or $50,000, whichever is less from your Roth 401(k), but you have to pay yourself back, and you have to pay interest on the money. You should absolutely ready the IRS guidelines because if you don’t pay on time there are penalties.

That ends the similarities and differences between Roth IRAs and Roth 401(k)s. Deciding which account is right for you takes some planning. If you can get your employer match from your Roth 401(k) and still max out your Roth IRA, I think you have the best of both worlds.

Please let me know if you have any questions, comments, or even stories of your own successes in the comments sections.

Keep the FIRE burning!

This article is for informational purposes only. As such, it should not be considered financial or legal advice. All information may not be completely accurate. Please, consult a financial professional before making any major financial decisions. Furthermore, review the IRS guidelines pertaining to your situation for additional information.