Many employers now offer Roth versions of their 401(k) plans. Though many people believe Roth IRAs and Roth 401(k)s (known formally as designated Roth 401(k) plans) are identical, there are important differences between the two types of retirement plans.
What is a 401(k)?
A 401(k) plan is offered by an employer to its employees. An employee can elect to have part of his or her compensation deferred into an account in the 401(k) plan instead of being included in the paycheck.
In a traditional 401(k) plan, the deferred amount isn’t included in gross income for income tax purposes (though it is subject to withholding for Social Security and Medicare taxes) up to a maximum amount determined by the IRS each year. The maximum tax-deferred amount will be $22,500 in 2023, and a plan participant who is age 50 or older can defer an addition $7,500 as a “catch-up contribution.” Additional amounts can be deferred into the plan, but they will be included in gross income. The total taxable and tax-deferred contributions can’t exceed $66,000 in 2023, or $73,500 for those ages 50 or older.
In a Roth 401(k), the amounts deferred into the account aren’t free of income taxes. They are included in the employee’s gross income, though the employee doesn’t receive them. The employee is contributing after-tax money and must pay the income taxes from other sources.
In either type of 401(k) plan, the employee can choose how the account is invested from among the choices offered by the plan. Income and gains from the investments aren’t taxed as long as they remain in the account.
When distributions are received from a traditional 401(k) account, they are taxed as ordinary income, except for any after-tax amounts that were in the account. Distributions from a Roth 401(k) aren’t taxed, whether the distributions are of contributions or accumulated income and gains.
What is an IRA?
An IRA, known formally as an individual retirement arrangement, can be opened at any financial services company that qualifies as an IRA custodian or trustee.
The individual is the owner of the IRA and determines how it is invested from among the choices offered by the custodian. When a broker or mutual fund company is the custodian, the IRA usually can be invested in any publicly traded asset. Some custodians allow the account to be invested in any asset that legally can be owned by an IRA, such as real estate, small businesses, mortgages, and others.
Total contributions to all IRAs owned by an individual will be limited to $6,500 in 2023 and an additional $1,000 can be contributed by those ages 50 and over.
Contributions to a traditional IRA are deductible when the IRA owner isn’t covered by an employer retirement plan and has adjusted gross income below certain levels. Contributions to a Roth IRA aren’t deductible. When the individual’s adjusted gross income exceeds certain levels, no contributions to a Roth IRA are allowed that year.
As with a 401(k) plan, investment income and gains are tax-deferred as long as they remain in the IRA. Distributions from a traditional IRA are taxed as ordinary income when they are of contributions that were deducted and of accumulated income and gains. Contributions that weren’t deducted are tax-free when distributed.
Distributions from a Roth IRA aren’t taxed as long as the owner meets the “five-year rule” by having a Roth IRA open for more than five years before the distribution.
Key Differences Between Roth And Traditional Accounts
Whether it’s an IRA or 401(k), there are key differences between Roth-type accounts, and traditional accounts. In the traditional accounts, most contributions have immediate income tax benefits. They’re either deductible (IRAs) or not included in gross income (401(k)s). Roth accounts have no upfront tax benefits. The contributions are of after-tax money.
But Roth accounts have significant tax benefits on the back end. Money distributed from them is tax-free in most circumstances.
Because of this difference, the general advice is to put money in a Roth-type account when you anticipate income tax rates increasing over time or otherwise expect that you’ll be in a higher tax bracket when distributions are taken from the account than when contributing money to the account.
The 401(k) Vs. The IRA
There are several factors to consider when you’re trying to decide whether to save through an IRA or 401(k) plan.
Most employers allow employees to take loans from their 401(k)s. Loans aren’t allowed from IRAs. They’re treated as distributions and will be taxable when taken from a traditional IRA.
An IRA is likely to have more investment options than a 401(k), though the 401(k) might have enough investment choices to meet your needs.
An IRA is more flexible. You can move the account to a different custodian whenever you want in most cases. You also can take distributions whenever you want, though they might be subject to a 10% early distribution penalty in addition to any income taxes if the distribution is before age 59 1/2. Distributions from a 401(k) generally aren’t allowed until you leave the employer. After that, you can leave the money in the 401(k) account, roll it over to an IRA, or roll it over to the 401(k) plan at a new employer, if the new plan allows it.
Most employers match part of the contributions employees make to their 401(k) accounts. This is free money to the employee. It doesn’t reduce regular compensation, and the matching contribution isn’t received unless the employee contributes a qualifying amount to the account. That’s why it’s often a good idea to contribute at least enough to a 401(k) plan to receive the maximum employer matching contribution.
Of course, if you want to save a lot of money, you don’t have to choose between an IRA and 401(k). You can save the maximum amount in each type of plan.
The Roth 401(k) Vs. The Roth IRA
When you decide you want a Roth-type account, keep in mind that the rules for the 401(k) and IRA aren’t the same. You should know the differences. The knowledge will help you decide which type of account to open. It also might influence a decision of whether to keep money in a 401(k) or roll it over to an IRA.
The contribution limits of the two accounts are different.
The maximum IRA contribution is $6,000 in 2022 ($6,500 in 2023) with an additional $1,000 catch-up contribution for those age 50 or older. But the maximum deferral to a 401(k), whether Roth or traditional, is $20,200 in 2022 ($22,500 in 2023) with an additional $6,500 catch-up contribution ($7,500 in 2023) allowed for those 50 and older.
There’s also an income limit for contributions to Roth IRAs. The maximum contribution begins to be reduced in 2022 for a single taxpayer when adjusted gross income exceeds $129,000 ($138,000 in 2023). For married couples, the phaseout begins at $204,000 ($218,000 in 2023) . There are no income limits for 401(k) contributions.
Employers can make matching contributions to Roth 401(k)s just as they can with traditional 401(k)s. The maximum of combined employer and employee contributions is the same for both traditional 401(k) and Roth 401(k) accounts: $61,000 or 100% of the employee’s compensation (whichever is lower) in 2022 or $67,500 for those 50 and older. In 2023, the limits are $66,000 and $73,500.
But employer-matching contributions to a Roth 401(k) are pre-tax dollars. They won’t be included in your gross income and will be placed in a traditional 401(k) account. Distributions from that account will be taxed as ordinary income.
Most Roth IRAs can be invested in any publicly traded investment. But the 401(k)s can be invested only in the investment options available through the plan, though the plan might have a brokerage window option that allows the account to be invested in almost any publicly traded investment.
Required Minimum Distributions
Many people don’t realize there’s a major difference in required minimum distributions (RMDs).
There are no RMDs for original owners of Roth IRAs. But there are RMDs for Roth 401(k)s starting at age 72, unless the account owner still is working for and owns less than 5% of the employer that sponsors the plan. These RMDs are tax-free, but you have to begin taking them.
Because of the RMD requirement for the 401(k)s, you might want to have one while working but roll it over to a IRA before age 72.
You can take tax-free loans from a Roth 401(k) under certain circumstances. But you can’t take a loan from an IRA — only distributions are allowed, and there will be a 10% penalty if they are taken before age 59½, unless you qualify for one of the exceptions.