When it comes to funding your retirement, there may be no more popular solution than the standard employer-sponsored 401(k). But that’s not the only option for putting your earned income to work for post-career life. A Roth IRA or Roth 401(k) could make sense based on your age, income and financial need.
There’s no disputing the potential power of contributing to a 401(k) plan as a path toward a financially stable retirement. Employer-sponsored plans offer generous contribution limits and potential “free money” in the form of employer match programs. But Roth IRAs and Roth 401(k)s can also be effective and tax-advantaged options for investors willing to pay the taxes upfront.
Roth IRAs were codified in 1998 and Roth 401(k)s followed eight years later. The primary benefit of Roth retirement accounts is that all earnings within the account grow and can be withdrawn tax-free, as opposed to a standard 401(k) where withdrawals are taxed as income. The Roth account options can be particularly attractive to younger investors and people who anticipate retiring in a higher tax bracket than the one they are currently in.
A Roth IRA differs from a traditional 401(k) in a few key ways. In addition to post-tax withdrawals, Roth accounts are subject to more strict annual contribution limits and income restrictions than standard 401(k)s. Key features and limitations of a Roth IRA include:
- Annual contribution limits of $7,000 in 2024 ($8,000 if you’re over the age of 50);
- Available only to investors with an adjusted gross income of $146,000 (single filer) or $240,000 (married filing jointly) or less in 2024;
- No required minimum distributions during your lifetime; and
- Available to be drawn on at any time – although if you withdraw before age 59 ½, you can only withdraw what you have contributed, not any interest earnings.
Roth products can be particularly beneficial to younger investors because – like any market-based investment – the sooner you begin investing, the more opportunity you have to earn compound interest on your contributions over time. Also — due to IRS regulations intended to prevent highly compensated employees from outsized tax benefit— as investors earn higher incomes in their mid-to-late career, they limit or eliminate their ability to contribute to a Roth IRA.
Investing in a Roth 401(k)
That limitation, however, does not exist with a Roth 401(k), making it a potentially attractive option for high-earners or participants looking to make contributions that would exceed the annual contribution limit of an IRA.
Much like a Roth IRA, a Roth 401(k) offers tax-free growth on earnings and withdrawals as contributions are made after-tax. There are a few specific differences in the two accounts, though. One primary difference is that a Roth 401(k) is sponsored and managed by your employer, which can limit who can contribute. Many employers are adding a Roth 401(k) option to their benefits package, but it may be unavailable to some. In addition to availability, a Roth 401(k) differs from a Roth IRA in that:
- It is employer-managed, meaning less control over how its funds are invested;
- Employers may contribute matching funds;
- Contributions are not subject to income limits; and
- There is a required minimum distribution beginning at age 75 (for those born after 1960).
With so many options available – Traditional 401(k), traditional IRA, Roth 401(k) and Roth IRA – which is the right choice for you? The answer lies in evaluating the advantages and limitations to each option.
In reality, investors shouldn’t look at Roth or traditional retirement accounts as an either/or proposition. Depending on your income needs and life stage, contributing to both can be an effective strategy. Your personal finances are unique and your retirement saving plan should likewise be unique to you. A financial advisor can help you determine an account and contribution strategy that is tax-advantaged and best fits your long-term needs.