Roth IRA vs Roth 401k: Which is Better?

Roth IRA

The Roth IRA, or individual retirement account, is an investing accout specifically designed to help you save for retirement. When you invest using a Roth IRA, you contribute dollars that you have already paid tax on. However, when you take those dollars out in retirement, you don't pay any taxes.

Roth 401k

A Roth 401k is an employee sponsored retirement plan. Similar to a Roth IRA, contributions made to a 401k are made with dollars that you have already paid tax on. When you take the dollars out of the account in retirement, you don't pay any taxes.

Keep in mind that if your employer offers a match on a Roth 401k, the match goes into a seperate, traditional 401k, meaning that you will pay taxes on the dollars your employer contributes when you take the money of the account in retirement. However that will be changing in 2024 thanks to the passing of the SECURE Act 2.0.

Due to the tax benefits, the IRS limits who is eligible for a Roth IRA. The eligibility requirements are linked to your income. If you file your taxes under the single, head of household, or married filing seperately tax filing status, your adjusted gross income has to be $138,000 or less to contribute the max amount to a Roth IRA.

Under these tax filing status you can also make a contribution to a Roth IRA if your adjusted gross income is between $138,000 and $153,000, but it will be a reduced amount. If you file your taxes under the married filing jointly, or qualifying widow(er) filing status, your adjusted gross income has to be $218,000 or less to contribute the max amount to a Roth IRA.

Under these tax filing status, you can also make a contribution to a Roth IRA if your adjusted gross income is between $218,000 and $228,000, but it will be a reduced amount.

On the contrary, there are no income limits you must meet to be eligible for a Roth 401k. The one "eligibility" requirement you might run into is that your employer only offers a traditional 401k, and does not offer a Roth 401k option. However, that seems to be changing as more employers are offering Roth 401(k)s.

The total amount that you can contribute to a Roth IRA is $6,500 per year, or $7,500 per year if you are 50 or older. A Roth 401k offers higher contribution limits. The total amount you can contribute to a Roth 401k is $22,500 or $30,000 if you are 50 or older. The amount you could have in a Roth 401k could potentially exceed these limits if your employer offers a match.

You can withdraw the money from both a Roth IRA and a Roth 401k tax free as long as a couple of rules are followed. 1) You have the held the account for a minimum of 5 years. 2) You are 59 and a half years old.

Additionally, you can pull out the base amounts you contributed to a Roth IRA or Roth 401k before meeting these rules since you have already paid taxes on those dollars. However, if you try to take out any money you have earned within a Roth IRA or Roth 401k without meeting the two rules listed above, you can incur a 10% penalty as well as additional income taxes.

A work around for this problem for the Roth 401k would be to take out a loan from the account. You are not allowed to take a loan from your Roth IRA. Keep in mind that most financial experts don't recommend taking loans from your retirement accounts.

A work around for this problem for the Roth IRA would be to use the withdrawal for a qualified exception. Some of these exceptions include withdrawals for qualified education expenses, $10,000 to buy your first home, withdrawals to cover disability, and more. When you withdraw money early from a Roth IRA for one of these exceptions, you don't have to pay an early withdrawal penalty.

A required minimum distribution is the minimum amount you must withdraw from certain retirement accounts per year once you reach a certain age as mandated by US tax laws. The good news is that a Roth IRA does not have any required minimum distributions. This means that you are never required to pull the money out of the account at a certain age which ultimately gives you more control of the account.

The Roth 401k does have a required minimum distribution starting at age 73. However, that is changing thanks to the passing of the SECURE Act 2.0 in 2022. Starting in 2024, required minimum distributions will be eliminated completely for the Roth 401k giving you more control of the account. You can learn more about the SECURE Act 2.0 by reading Bankrate's summary here.

Since a Roth 401k is an employer sponsored plan, you are typically limited to a select amount of investment options to hold in your Roth 401k. These investment options are typically a selection of low cost mutual funds.

On the flipside, a Roth IRA allows you to invest in almost anything you want. Since a Roth IRA is held outside of work, your investment options are almost endless. You can invest in indidivual stocks, investment funds, bonds, cash equivalents, and more.

In other words, you will have a lot more flexibility on the investments that you can hold in a Roth IRA then you will have on the investments you hold in a Roth 401k.

Deciding between a Roth IRA and a Roth 401k will ultimately come down to your individual needs, goals, and preferences. However, there are some things you can look at to help you decide which account is better for you.

Do you qualify for a Roth IRA?

The first question you can ask yourself to decide between a Roth IRA and a Roth 401k is if you qualify to have a Roth IRA. Remember, eligibility for a Roth IRA is determined by your income. (You can click here if you need a quick refresher.)

If you don't qualify for a Roth IRA, it is an easy choice: you can contribute to a Roth 401k. On the flipside, it could be that your employer does not offer a Roth 401k option and only offers a traditional 401k option. In this case, you can contribute to a Roth IRA. Ideally, you want to have access to both options.

Does your employer offer a match on your Roth 401k?

One of the biggest advantages of investing in a Roth 401k over a Roth IRA is your employer's match. Say for example that your employer offers a 3% match to your Roth 401k based upon your compensation. So, if you make $100,000 per year and put $3,000 into your Roth 401k, your employer would match that by contributing another $3,000 into your Roth 401k.

Having an employer match your contributions to your Roth 401k can be a good reason to choose a Roth 401k over a Roth IRA. These additional contributions can help grow the value of the investments within your Roth 401k faster and larger over time.

Consider the amount you can contribute to each

The amount that you can contribute to a Roth IRA is much less than the amount you can contribute to a Roth 401k. If you are a high income earner or have a lot of disposable income to invest, having the higher contribution limits of a Roth 401k can be beneficial.

If you don't think that you will be able to invest more than the contribution limits of a Roth IRA ($6,500 per year or $7,500 per year if you are 50 or older) it might make more sense to stick with a Roth IRA since you will have more control over your investments.

Consider the investment options of both

Although a Roth 401k has the benefits of an employer match and higher contribution limits, you don't have as much control as what you invest in when compared to a Roth IRA. An employer sponsored Roth 401k will only offer you a set amount of invesment options, whereas a Roth IRA will offer you endless invesment options.

It can be both and, not one or the other

Keep in mind that you can have both a Roth IRA and Roth 401k. You don't necessarily have to choose one over the other. In fact, it can be ideal to use both accounts as each account offers a few different benefits. Lets look at how to do that below.

1) Contribute enough to a Roth 401k to get an employer match

If your employer offers a Roth 401k with a match, you can invest enough into the account to get your employer's match. So, if you make $80,000 per year and your employer offers a 4% match, you should contribute $3,200 (4% of your annual salary) so that your employer will match that with another $3,200.

Having a match can boost how much money you have in your Roth 401k over long periods of time. The average 401k match is typically between 4% and 6% of your salary. If your employer offers a Roth 401k, but does not offer a match, jump straight to step 2 below.

2) Open a Roth IRA and max fund it

Once you contribute enough to a Roth 401k to get your employer match, it might be a good idea to start diverting dollars to a Roth IRA if you still have money you are able to invest. You might be asking yourself why?

A Roth 401k offers many benefits, but one of the disadvantages is that you don't have as much control over your investments. You only get to choose from select investment funds for your plan. Investing dollars into a Roth IRA will give you much more control over what you are able to invest in.

You can look for other investments to hold within a Roth IRA that are not available through your Roth 401k if it makes sense for you to do so. Contribute the maximum amount you are allowed to a Roth IRA ($6,500 per year or $7,500 per year if you are 50 or older).

3) Jump back to your Roth 401k

If you still have money you are able to invest after going through options one and two, you can jump back over to your Roth 401k. A Roth 401k will provide the tax benefits of the Roth IRA, but also has a much higher contribution limit meaning that you can invest more money into a Roth 401k.

Since a Roth 401k is an employer sponsored retirement plan, you will have to speak to your company HR department to complete the set up process. A Roth IRA can be opened at a variety of places including online brokers and robo advisors. If you need help setting up a Roth IRA, you can check out our complete guide here.

The bottom line is that both the Roth IRA and Roth 401k are accounts you can use to help save for retirement. With both accounts you contribute dollars that you have already paid taxes on, but then enjoy tax free withdrawals from the accounts in retirement.

A Roth 401k will allow to contribute more to the account than a Roth IRA, but a Roth IRA gives you more control over the investments you can hold within the account. At the end of the day, using the accounts in tandem might be your best option.