When you contribute after-tax dollars to a Roth 401(k) or Roth IRA, your money grows without the drag of taxes each year and you can set yourself up for tax-free withdrawals in retirement. However, there are some important distinctions between these two accounts that could have important implications for your retirement finances. Here’s are some of the major ways the rules differ between Roth 401(k)s and Roth IRAs.
How to participate. You can only participate in a Roth 401(k) if your employer provides one. Companies are increasingly adding a Roth 401(k) to their retirement benefit plans. Over half (56 percent) of Vanguard 401(k) plans had a Roth option in 2014, up from 42 percent in 2010. However, not many employees elect to use this benefit. Only 14 percent of workers save in the Roth 401(k) when it’s offered.
Roth IRAs are available to people with earned income whose adjusted gross income is less than $132,000 for individuals and $194,000 for married couples in 2016. Eligibility to contribute the full amount to a Roth IRA starts to be phased out if your adjusted gross income tops $117,000 for individuals and $184,000 for married couples.
401(k)s have bigger contribution limits. Roth 401(k)s have a much higher contribution limit than Roth IRAs. You can save as much as $18,000 in a Roth 401(k), and make catch-up contributions worth an additional $6,000 if you’re age 50 or older. Savers can only contribute up to $5,500 to a Roth IRA, and the catch-up contribution is limited to another $1,000.
IRAs have a later contribution deadline. Roth 401(k) deposits generally need to be made during the calendar year. You can make Roth IRA contributions up until your tax filing deadline in April. However, you will need to indicate which tax year you would like your Roth IRA contribution to be applied to. If you don’t specify otherwise, Roth contributions will be automatically applied to the calendar year in which the deposit is made.
Your 401(k) match will go in a separate account. Some employers match Roth 401(k) contributions, but the company contribution won’t be put in the Roth account. The 401(k) match will be deposited in a traditional 401(k) account, and you will owe income tax on the employer contributions and the investment earnings when you withdraw the money from the account. There’s no option to get a match on your Roth IRA contributions.
Roth IRAs don’t have withdrawal requirements. One of the major perks of saving for retirement in a Roth IRA is that there are no withdrawal requirements in retirement. The earnings will continue to grow tax-free until you withdraw the money or pass it on to your heirs. However, distributions from Roth 401(k)s are typically required each year after age 70 ½. If you are still working for a company you don’t have an ownership stake in, you can delay withdrawals from the Roth 401(k) until you actually retire.
Different application of the early withdrawal penalty. If you need to tap into your Roth account savings before age 59 ½, you might need to pay a 10 percent early withdrawal penalty on the portion of the withdrawal that comes from investment earnings. And that penalty is applied differently depending on what type of account the money is being withdrawn from.