Roth accounts are popular retirement savings options for many. Roth IRAs and Roth 401(k) accounts can both be options for some investors. What’s the difference between these two types of accounts?
Whether an IRA or within a 401(k) plan, Roth accounts have a number of characteristics in common:
- Contributions are made on an after-tax basis.
- Money in the account grows tax-free until withdrawn.
- Qualified distributions are not subject to taxes as long as certain conditions are met.
A key difference is that a Roth IRA is an IRA account that is opened and controlled by the account owner at a custodian of their choosing. A Roth 401(k) is part of a 401(k) plan offered by an employer, or in some cases, can be contained in a Solo 401(k) opened by someone who is self-employed.
Like all IRA accounts, Roth IRAs are subject to annual contribution limits of $6,000 with an additional $1,000 catch-up contribution for those who are 50 or over at any point during the year.
A Roth IRA can be opened at any number of custodians, brokers and mutual fund companies such as Fidelity, Charles Schwab (SCHW) - Get Report, Vanguard, T. Rowe Price (TROW) - Get Report and a host of others.
Roth IRA accounts have no required minimum distributions (RMDs), which make them a great tool for estate planning. This extends to spousal beneficiaries who opt to treat a deceased spouse’s Roth IRA account as their own under the rules.
There are income caps that can limit your ability to contribute directly to a Roth IRA. For 2020, these limits are:
- There is no reduction in the amount you can contribute if your income is below $124,000.
- There is a contribution phaseout if your income is ranges from $124,000 to $139,000.
- No Roth IRA contributions are allowed if your income exceeds $139,000.
Married Filing Jointly
- There is no reduction in the amount you can contribute if your income is below $196,000.
- There is a contribution phaseout if your income is ranges from $196,000 to $206,000.
- No Roth IRA contributions are allowed if your income exceeds $206,000.
Note that income in this context refers to modified adjusted gross income (MAGI).
The Five-Year Rule
The five-year rule states that your first Roth IRA account must have been open for five years for distributions to be qualified.
Account holders can always withdraw the amount of their own contributions to the account free of taxes and the 10% penalty.
Qualified distributions are tax and penalty-free, if you have met the 5-year rule and:
- You are at least age 59½
- The distribution is connected to your death and involves the distribution of the account to your beneficiaries.
- It is in connection with disability.
- It is for a qualifying first-time home purchase by you or a qualifying family member.
Distributions that do not meet the above criteria but that will generally incur taxes on any earnings in the account, but no penalty include those for:
- Distributions that are part of a series of substantially equal payments for a minimum of five years or until you reach age 59½, whichever is longer under the rules.
- Unreimbursed medical expenses exceeding 10% of your adjusted gross income.
- The payment of medical insurance premiums if you are unemployed due to a job loss.
- The cost of qualifying higher education expenses for you and/or a family member.
- The payment of an IRS levy
- A qualified reservist distribution
- A qualified disaster recovery distribution
If the distribution doesn’t meet one of the two types listed above, it is likely a non-qualified distribution and could be subject to both taxes and a 10% penalty.
A designated Roth 401(k) account, in the wording of the IRS, is simply an option for contributions that is offered by some 401(k) sponsors. For plans that offer a Roth option along with the traditional option, participants can contribute to either or both options up to the total contribution limits for 401(k) plans which are $19,500 with an additional $6,500 in catch-up contributions for those 50 or over for 2020.
For those who are self-employed, some custodians also allow a Roth option for your solo 401(k). This would work essentially the same way as with an employer-sponsored plan.
Unlike a Roth IRA, there are no income limits for contributing to a Roth 401(k) account. Note that by law any employer matching contributions must be made into a traditional Roth account.
Another key difference from a Roth IRA account is that Roth 401(k) accounts are subject to RMDs at age 72. A way around this is to roll the account over to a Roth IRA. If you are still working at the company, your company has made the proper amendment to their plan and you are not a 5% or greater owner of the company, you may be able to defer RMDs on this account with your current employer.
Rollovers to an IRA account must be made to a Roth IRA account of any portion of your 401(k) balance that is in the Roth option, amounts in a traditional account need to be rolled over to a traditional IRA account.
If your plan allows for them, you can take a 401(k) loan out against your Roth account balance. IRAs, of course, do not allow for loans. Generally, all rules for distributions, including hardship withdrawals, that apply to a traditional 401(k) account will apply to a Roth account.
Qualified and non-qualified distributions pertain to Roth 401(k)s as well. The five-year rule and the age 59½ threshold apply here. Distributions made due to death to account beneficiaries or due to the disability of the account holder will not be subject to taxes or penalties.
As with a Roth IRA, the account holder’s contributions to the account can always be withdrawn tax- and penalty-free. In the case of a withdrawal that is not otherwise qualified, taxes on the withdrawal will be prorated between the account holder’s own contributions and earnings, any taxes and penalties will be prorated this way as well.