Roth IRA or Roth 401(k)?

February 18, 2016

We’ve recently received several calls on our Financial Helpline from people who entered their Roth 401(k) contributions as Roth IRA contributions in tax software and were told that they had over-contributed. Since Roth 401(k) plans are relatively new, it’s easy to get these mixed up but the differences are important and not just when filing your taxes. Let’s start with the similarities. Both accounts allow you to contribute after-tax dollars that can grow to be tax-free after age 59 ½ as long as you’ve had the account for at least 5 years. Now let’s look at the differences:

Can you contribute?

A Roth 401(k) has to be offered by your employer. If it is and you’re eligible to contribute, you’re good to go. A Roth IRA has income limits. (However, there is a way to get around them.)

How do you contribute?

If your employer offers you a Roth 401(k) option, the contributions are deducted from your paycheck for that tax year. With a Roth IRA, you have to open the account and make the contributions yourself, either by writing a check or having an automatic transfer from your bank account. You also usually have until April 15th (April 18th this year) to make a contribution for the previous year. Not sure where to open a Roth IRA? Here are some low cost options.

How much can you contribute?

The total limit for employee traditional and Roth 401(k) contributions is $18,000 ($24,000 if you’re over age 50 this year) for 2016. For IRAs, the total limit is a much lower $5,500 ($6,500 if you’re over age 50 this year) for 2015 and 2016. The Roth IRA contribution limit can also be reduced if your income is in the phase-out range. Contributing to one doesn’t affect how much you contribute to the other so you can do both if you’re eligible. 

What can you invest the accounts in?

With a Roth 401(k), you’re limited to the choices your plan offers but this can often include options not otherwise available like higher-yielding stable value funds and mutual funds with reduced fees. With a Roth IRA, you can invest in almost anything, including stocks, bonds, mutual funds, annuities, and even gold coins, real estate, and your own business if you have a self-directed Roth IRA.

How can you get the money?

You can take money out of a Roth IRA anytime. With a Roth 401(k), you’re generally limited to loans and/or hardship withdrawals before age 59 ½ if you’re still employed there and if the plan allows them. Many plans also allow you to take withdrawals at age 59 ½. You can withdraw money after you leave your employer as well.

Are there penalties on withdrawals?

Roth earnings withdrawn before age 59 ½ are subject to taxes and a 10% penalty unless you meet certain exceptions. One of the big differences is that with a Roth IRA, your withdrawals are considered contributions first. That means you can withdraw the sum of your contributions at any time without tax or penalty. With a Roth 401(k), withdrawals are considered contributions and earnings in the same proportion as they exist in your account. Unlike with a Roth 401(k), Roth IRA earnings can also be withdrawn penalty-free for education expenses and up to $10k (lifetime limit) for a home purchase if you haven’t owned a home in the last 2 years.

Can you roll money from one to another?

You can roll money from a Roth 401(k) to a Roth IRA but not the other way around.

What’s the bottom line?

Roth IRAs generally provide more flexibility, both in terms of how the money is invested and withdrawn. However, Roth 401(k) accounts offer greater convenience and allow you to contribute more. They’re both excellent ways to shield your future income from taxes so if you’re eligible, you may want to contribute to both!