This week has been filled with discussion around retirement planning. For a final post this week on the topic, I want to talk about Roth Individual Retirement Accounts (IRAs) and how they compare against Roth 401Ks. Both retirement plans offer significant tax advantages, but they do have some nuances that should be considered before choosing one over the other. Let’s review.
What is a Roth IRA?
A Roth IRA is an individual retirement account that allows an individual to contribute post-tax dollars into an account that grows tax-free. This means that individuals will not have to pay taxes on the money they withdraw in retirement. It is important to note that an individual must be at least 59.5 years old and have had a Roth IRA account for at least five years to make tax-free withdrawals. There are some exceptions to this withdrawal penalty, which include using the funds to purchase a first home and other qualified medical expenses. The point of a retirement account is to avoid withdrawing from it until retirement, but life happens and sometimes we need to cover expenses. It would be wise to verify any penalties before withdrawing and that can be done via a conversation with a financial professional or the broker that manages the IRA.
What is a Roth 401K?
Recall that a Roth 401K is a type of 401K retirement savings plan that allows an employee to contribute post-tax dollars. This means that the money contributed to the Roth 401K has already been taxed and will not be taxed when the money is withdrawn in retirement. Like the Roth IRA, the Roth 401K requires an individual to be at least 59.5 years old to withdraw from the fund tax-free. Additionally, the same exceptions apply to the Roth 401K.
Comparing a Roth 401K against a Roth IRA
Roth IRA Advantages
The primary advantage of the Roth IRA is that the money grows tax-free. Individuals do not have to pay taxes on earnings in the account, which can help save a lot of money over time. In addition, there are no required minimum distributions (RMDs). Unlike traditional IRAs and 401Ks, the Roth IRA does not have RMDs. This means that individuals can let the money grow tax-free for as long as they want without being forced to take money out of the account. Additionally, the Roth IRA does offer some flexibility with exceptions on withdrawals. It is very important to discuss the withdrawal penalties with the broker or a financial professional before making any decisions to withdraw money from the Roth IRA early.
Roth IRA Disadvantages
The biggest disadvantage to the Roth IRA is the income limit for contributions. These limits can change and it would be wise to discuss the updated limits with a financial professional or review the IRS website. As of this writing, in May 2023, the IRA income limits are below:
Modified AGI stands for Modified Adjusted Gross Income (MAGI), which is a measure that is used by the IRS to determine an individual’s eligibility for certain tax deductions, credits, and retirement account contributions. MAGI starts with Gross Income and subtracts or adds back certain deductions and adjustments. To better understand MAGI calculations, consult with a CPA or tax professional to see how it is calculated using your own Gross Income. For a simple example, suppose someone has a gross income of $50,000 and they make a $2,000 contribution to a traditional IRA in a year. Further suppose they also paid $1,000 in student loan interest for the year. First, in this very simple example, this individual’s adjusted gross income (AGI) would be $50,000 – $2,000 – $1,000 = $47,000. However, to arrive at the individual’s MAGI, we would need to add back the $2,000 to the AGI to arrive at a MAGI of $49,000. Again, this is a very very simple example and should not be construed as tax advice. Only education. Find a CPA to better explain these calculations and how they apply to your situation.
In the above picture, you can see that it says, “up to the limit” under the “Then you can contribute…” column. This is because Roth IRAs have yearly contribution limits. As with the MAGI, these limits can change, but as of 2023 the contribution limits are $6,500 for everyone under age 50 and $7,500 for individuals 50 years old or older.
Roth 401K advantages
A primary advantage of the Roth 401K is the fact that there are higher contribution limits. As mentioned previously, these limits can change, but for 2023, the 401K contribution limits are $22,500. Additionally, Roth 401Ks can also come with employer matching contributions. This can help an employee potentially double their savings. Like the IRA, the Roth 401K also grows tax-free, so individuals will not have to pay taxes on the earnings in the account.
Roth 401K Disadvantages
There is no flexibility when it comes to withdrawals. Although exceptions do exist, it might be more difficult to withdraw money from the Roth 401K before turning 59.5 years old. There might be limited investment options. Often the investments available to employees are what the employer offers, which can mean that an individual investing in an IRA might have more options available to them to invest in as opposed to the Roth 401K provided by an employer. Finally, required minimum distributions (RMDs) are a significant disadvantage to the Roth 401K. This means that starting at age 72, individuals will be required to withdraw a certain amount from the account each year, even if they do not need the money.
So what plan is better?
As with everything in personal finance, this will depend on personal goals, preferences, and circumstances. We just want to bring the information to you to help you better understand the products that exist in the world and pick the one that is best for you. If you are self-employed or do not have access to a 401K plan through an employer, a Roth IRA might be the better option. This will allow you to have control over your investments and be able to choose from a wider range of options.
On the other hand, if you have access to a Roth 401K through your employer, this might be the better option to maximize contributions with matching contributions. The contribution limits are significantly higher for the Roth 401K, so that can help boost savings. If you meet the eligibility requirements for both a Roth IRA and a Roth 401K and max out the contributions to the Roth IRA in a year with plenty of time left in the year, you could also contribute to the Roth 401K. So, it is possible to work with both, provided you are eligible.
Disclaimer: I am not a financial advisor. The content on knowxchange.com or “this site” are for educational purposes only and merely cite my own personal opinions and experiences. In order to make the best financial decision that suits your own needs, you must conduct your own research and seek the advice of a licensed financial advisor if necessary. Know and understand that all investments involve some form of risk. There is no guarantee that you will be successful in making, saving, or investing money. Additionally, there is no guarantee that you won’t experience any loss when investing. Please seek the advice of a financial professional and do your own research.