Roth IRA vs. Roth 401(k). What’s the difference?
Roth IRAs and Roth 401(k) are different types of retirement savings accounts. Both options have pros and cons; in this article, we consider both.
When you’re comparing Roth IRAs and Roth 401(k)s, it’s important to remember that there’s no all-encompassing answer to which one is best. It all depends on your finances, your age and when you want to start drawing on your money.
What is a Roth IRA?
The Roth IRA, or individual retirement account, was launched in 1997 as part of the Taxpayer Relief Act. The key difference compared with traditional IRAs is that they are funded using after-tax dollars, so qualified distributions are tax-free.
Unlike 401(k) plans, a Roth IRA is not sponsored by your employer, so you can keep investing in the same plan even when you change jobs. You can choose the financial institution you want to hold custody of your IRA and the investments you want to invest, then decide how much to contribute each year.
What is a Roth 401(k)?
A 401(k) is a retirement savings plan many US employers offer that provides tax advantages for you as a saver. It takes its name from a US Internal Revenue Code (IRC) section. When you sign up for a 401(k), you agree to have a percentage of your paycheck put directly into an investment account. Your employer can also match some or all of this contribution.
The Roth 401(k), introduced in 2001, takes key advantages from the 401(k) and Roth IRA, giving you a unique option when planning retirement. Compared with traditional 401(k)s, the big difference is that income tax is paid on money before it’s deposited in the investment account, so your withdrawals will not be taxed.
Roth IRA v Roth 401(k): five key differences
Roth IRA or Roth 401(k) plans both use after-tax dollars, so you don’t have to pay income tax when you receive distributions. There are some key differences to consider:
1. Income limits: Roth IRAs have an income limit, so currently, if you have an adjusted gross income (AGI) of $153,000, or as a married couple, you and your partner made over $228,000, you won’t be eligible. There is no income limit on a Roth 401(k), so even if you have a high income, you can still contribute. Additionally, Roth 401(k)s have higher contribution limits.
2. Required minimum distributions: the Roth 401(k) requires you to take required minimum distributions (RMDs) from the age of 73 if you were born between 1951 and 1959 or 75 if you were born in 1960 or later. If you don’t meet your RMD during the year, you might have to pay 25% of the shortfall as a penalty.
With a Roth IRA, you don’t have to take RMDs. This flexibility allows you to contribute to your account as long as you like, growing your funds indefinitely. You can also pass your Roth IRA to your spouse and descendants.
3. Investment options: when you choose a Roth 401(k), your investment options are limited to those offered by the plan’s administrator – usually a range of mutual funds.
In contrast, Roth IRAs provide a much broader range of investments. You can also shop around to find the lowest transaction and administrative expenses.
4. Contributions and limits: perhaps the biggest plus point with Roth 401(k)s is the potential for matching contributions from your employer. Employers are offered a tax incentive for participating and can contribute an annual maximum of $22,500 in 2023.
You can add a catch-up contribution of $7,500 if you turn 50 by the end of the year, and from 2024, this will be adjusted for inflation and cost of living changes.
One snag to be aware of is that your employer may match your contribution with pre-tax dollars, so when the plan is funded using post-tax dollars, the funds and their earnings will be placed in a regular 401(k) account. This would mean you must pay tax on the money and its earnings when you take distributions.
By contrast, Roth IRAs have a far lower contribution limit – $6,500 for 2023 – and are entirely self-funded. There are no employer contributions.
5. Withdrawals: a Roth 401(k) gives limited access to your funds before the age of 59½. You can’t take cash out of your plan without incurring a 10 percent penalty.
The Roth IRA is different. You can withdraw an amount equivalent to your contribution without penalty, but any earnings accrued will attract a 10 percent charge – if you’re under 59½.
There are some exceptions. If you’re a first-time home buyer or are dealing with childbirth costs, you can withdraw earnings from a Roth IRA free of penalty if you’ve held the account for less than five years or free of penalty and tax if you’ve had it for more than five years.
So, which is better, a 401(k) or an IRA?
As mentioned, both approaches have pros and cons, and your individual status and circumstances dictate the best option for you.
For example, a Roth IRA is designed for people earning a maximum of $153,000, so if you earn more, you’re not eligible. Also, IRAs offer plenty of investment fund options where 401(k)s are restricted.
On the flip side, a Roth 401(k) allows you to contribute much more each year and comes with matching contributions from your employer.
The bottom line
Both Roth IRAs and Roth 401(k)s can work well if they match your circumstances. There’s always the option to switch from one to the other to capitalize on the contrasting benefits.
When choosing the right retirement account, it’s always best to get professional expert advice. A financial advisor can tell you all about each plan type's details, rules and restrictions and help clarify your priorities and the best way forward.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.