South Florida Sun-Sentinel (Sunday)
Roth IRAs vs. Roth 401(k)s
Roth IRAs and Roth 401(k) plans are both great ways to invest for retirement, each conferring significant tax advantages. But don’t make the mistake of mentally equating them. They differ, and it’s important to understand how.
Recently, Ed Slott and Co. published a useful discussion of the differences on the company website (www.irahelp.com). I’ll recap some of the points made.
In 2021 and 2022, individuals with sufficient income can contribute up to
$6,000 per year ($7,000 for individuals 50 or older) to a Roth IRA as long as their income does not exceed specified limits. For married couples, the modified adjusted gross income (MAGI) for
2021 must be under $208,000; for single filers, the MAGI must be under $140,000. Employees eligible to contribute to Roth
401(k)s in 2021 can contribute up to
$19,500 (up to $26,000 for employees
50 or older); in 2022 up to $20,500 (up to $27,000 for employees 50 or older). For Roth 401(k) employees, there are no restrictions based on income levels.
There is no combined limit for contributions to Roth IRAs and Roth 401(k)s. So, for example, for 2021, if your employer offers a Roth 401(k) account, you could contribute a combined total of $25,500; if you are 50 or older, you could contribute $33,000.
The advantages of Roth 401(k)s over Roth IRAs are:
Higher annual limits and no income restrictions.
Stronger creditor protection. ERISA offers protection against non-bankruptcy creditor lawsuits. This protection does not apply to Thrift Savings Plan and solo 401(k) accounts.
Matching employer contributions in some plans.
Loan options available. Some plans offer life insurance options.
At age 55 or older, no early distribution penalty.
The advantages of Roth IRAs over Roth 401(k)s are:
No lifetime RMDs for both owners and surviving spouses. Roth 401(k)s are subject to RMDs.
More investment options. The only restrictions are associated with most collectibles, life insurance and S corporation stock.
Better accessibility. Roth IRA accounts can be withdrawn at any time. (However, there can be an early withdrawal penalty before 59 ½.) Employees still working with Roth 401(k) accounts cannot make withdrawals before 59 ½ except for financial hardship.
Easier to satisfy “qualified” distribution rules. Earnings from both Roth IRAs and Roth 401(k)s can be withdrawn tax free if qualified. Qualified distributions are based on a “triggering effect” and satisfying a five-year holding period for both Roth IRAs and Roth 401(k)s. The triggering effect is age 59 ½, death or disability. A first-time home purchase also qualifies for Roth 401(k)s. The fiveyear holding period is easier to meet for Roth IRAs. The five-year period starts on Jan. 1 of the year the IRA owner opens any Roth IRA. For Roth 401(k)s, the fiveyear period begins Jan. 1 of the year the employee makes contributions to that
401(k) plan. So, if an employee maintains more than one 401(k) plan, he must keep track of the starting date separately.
More favorable “non-qualified” distribution rules. Contributions to Roth IRAs are tax free and penalty free no matter which account contributions to Roth IRAs are made. Conversions to Roth IRAs are always tax free but are subject to penalty if the withdrawal is made before 59 ½ and within five years of the conversion. Earnings from Roth IRAs are possibly subject to penalty when they are non-qualified. When non-qualified withdrawals are made from Roth
401(k)s, a portion of the distribution is usually taxable because pro rata rules apply. For example, the taxable portion is the percentage of the amount of earnings divided by the total value of the Roth account balance.
Bottom line: There are advantages to both types of accounts. If you meet the eligibility requirements, there is no reason why you can’t use both options to your advantage.