By Sarah Brenner, JD
Director of Retirement Education
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More 401(k) plans are starting to offer Roth options. If you now have this option, you may be wondering what the difference is between a Roth IRA and a Roth 401(k). Which account is right for you?
These accounts have a lot in common. Both offer the ability to make after-tax contributions now in exchange for tax-free earnings down the road if the rules are followed. However, there are some important differences between the two plans that you will want to understand.
One major difference is the amount that you may contribute. Your Roth IRA contribution is limited to a maximum of $6,500 for 2023 if you are under age 50. If you are age 50 or older this year, you may contribute up to $7,500. A Roth 401(k) offers much higher limits. You can defer $22,500 for 2023, or $30,000 if you are 50 or over.
Roth 401(k)s do not have any income limits on contributions. If you are a high earner, you will still be able to make deferrals. That is not the case for Roth IRAs. In 2023, your ability to contribute to a Roth IRA will begin to phase out when your income exceeds $138,000 ($218,000 if you are married, filing jointly). If your income is too high and you would like to fund a Roth IRA, you may want to explore the back-door Roth IRA strategy as a way around these limits.
Roth IRAs have always offered the advantage of no required minimum distributions (RMDs) during your lifetime. This has not been the case for Roth 401(k)s. However, SECURE 2.0, the new law passed last year, will change that starting in 2024. Beginning next year, you will no longer need to take RMDs from your Roth 401(k) during your lifetime. At your death, eligible designated beneficiaries of your Roth IRA or Roth 401(k) will be subject to RMD requirements. However, most non-spouse beneficiaries of these accounts will be subject to a 10-year payout period under the SECURE Act.
Roth 401(k) funds can be rolled over to a Roth IRA. However, the opposite is not true. You may not roll over your Roth IRA to your Roth 401(k)
When it comes to funding either a Roth 401(k) or a Roth IRA, the goal is to take tax-free distributions someday. For this to happen, you must have a qualified distribution. The rules for qualified distributions from Roth IRAs are more favorable than those for Roth 401(k)s. You can take a qualified distribution for a first home purchase, which is not allowed with a Roth 401(k). Also, your five-year period starts with your first contribution to any Roth IRA. For Roth 401(k)s, the five-year period for qualified distributions applies separately to each plan.
What if you take a distribution that is not qualified? The rules for nonqualified distributions are also more favorable from Roth IRAs than Roth 401(k)s. With a Roth IRA, the ordering rules say that earnings will leave the Roth IRA last. This means that taxable funds will come out only after all your other Roth IRA funds have been distributed. With Roth 401(k)s you are not so lucky. A distribution that is not a qualified distribution is subject to the pro-rata rule. A portion of each distribution will be taxed.
Which is Best for You?
You now understand there are some advantages to a Roth 401(k) especially when it comes to contributions. However, a Roth IRA may be preferable when it comes to taking distributions. Which is best for you? There is not one answer that is right for everyone, and it is not an all-or-nothing decision. If you are in the fortunate situation of having enough funds and are eligible for both a Roth IRA and Roth 401(k), you can contribute to both accounts! If you have questions about your own situation, you should consider meeting with a knowledgeable financial advisor.