Roth 401K and Roth IRA Accounts

March 18, 2023 Published by

This article will discuss some of the benefits of Roth 401K and Roth IRA accounts and determine which type of account is best for your investment objectives. Some high-income investors may not be allowed to open a Roth IRA account, and some companies may not offer their employees Roth 401K accounts. In some cases, both options may be available, and it may be in the investor’s best interest to open both of these accounts. Roth retirement accounts can be a solid alternative to traditional IRA accounts, as you do not have to worry about paying taxes on distributions after retiring.

Roth 401 K

A Roth 401K is a type of employer-sponsored retirement plan in which someone funds the investment account after paying income taxes on their salary. Employees who use this plan typically elect to have a percentage of their income go towards this Roth 401K account due to the long-term benefits of this retirement account. Many employers also choose to match the contribution that employers make in these plans. If you want to use this retirement plan, you need to check with your employer and ensure that they provide you with this option.

Benefits of the Roth 401K

There are many benefits associated with opening a Roth 401K account:

Avoiding taxes when you retire: When you fund a Roth 401K account, you pay taxes on your income before adding money to the account. Therefore, any distributions are not taxed at all once you retire, as long as you wait five years and follow all of the other regulations before taking out funds from your account.

Qualified withdrawals: Any qualified withdrawal is tax-free, provided that you have maintained the account for five years and waited until you are 59.5 years old. Moreover, any penalties for early withdrawals are waived if you meet the requirements. Some examples of exceptions include paying for medical expenses that exceed 10% of your income, death, disability, or call to active duty if you are in the military.

Less complex: Many people may prefer Roth 401K accounts because they can pay taxes immediately and not worry about what tax bracket they will be in in the future. Moreover, this can be a strategic move for younger individuals who contribute while in a lower tax bracket.

Employer Match: One of the benefits of a Roth 401K account is that your employer will sometimes match your contribution. Companies have a clear policy about this, and you can check with human resources about it before deciding how much you want to contribute.

Contribution limits: Contribution limits for Roth 401K accounts are much higher, relative to other types of accounts. Moreover, the IRS announces updates each year, in which the contribution limit may be increased due to inflation or other factors. You can contribute up to $23,000/year combined in your Roth 401K and traditional 401K IRAs.

No Income Limits: Other types of similar plans, like Roth IRA accounts, have income limits, so some people are not eligible to open this account. However, anyone can participate in this type of plan if their employer offers it to them.

Fees: Another reason that Roth 401K plans are a good idea, especially for younger employers, is because the fees for smaller balances tend to be lower. This can help you get a strong start on your retirement at the beginning of your career, by avoiding excess management fees.

Overall, the main benefit of considering a Roth 401 K plan over a traditional 401 K plan is the added flexibility, as you do not have to worry about paying income taxes on these funds when you retire. However, the cost is that you will make smaller contributions, as you have to pay taxes on this income before making a contribution. It may be worthwhile for you to talk to a financial advisor about this and attempt to predict what income bracket you will be in throughout your career, as this is one of the most important factors to consider.

However, you should still consider the following:

Not all companies offer these plans: You will need to check with your company to see if they offer Roth 401K plans. Some plans may only offer traditional 401K plans, or not offer either option. In this case, it is best to look into a Roth IRA or other options.

Be mindful of penalties: Even though you already pay taxes on your income before funding an IRA, you could still have to pay penalties if you withdraw your funds before five years and do not meet some of the eligibility criteria for hardship distributions. Moreover, you can only withdraw contributions, but can’t take out any earnings made from investing.

Paying taxes: You have to pay taxes before contributing to any type of Roth IRA, which means that your contributions are smaller. A traditional 401k could be a superior option for some, especially if you believe you will be in a lower tax bracket upon retiring.

Contribution Amounts for Roth 401Ks

You can contribute the following amounts:

  • Contributions were limited to $20,500 in 2022
  • However, this increased to $22,500 in 2023
  • The amount may increase in the future based on inflation

If you plan to contribute to multiple types of 401K employer-sponsored plans, it is imperative to note that the income limits apply to all plans. The limits apply to the total amount of your salary deferred, not the type of account. For example, if you are also participating in another 401K plan, then the combined amounts of both plans need to be at or below the limit set by the IRS. For many people who don’t know what their future tax brackets will be, it can make sense to make an equal contribution to each account.

Qualified Distributions

You can still avoid paying a penalty if you withdraw this plan before turning 59.5 years old for some of the following reasons:

  • Disability
  • Death
  • When you turn 59.5 years old
  • Other major medical expenses

When to Begin Making Distributions

You can start anytime after you turn 59.5 years old and do not need to worry about any taxes or penalties if you start at this age. This fact is good news for anyone who still plans to work in their 60s, as they would not have to worry about their income tax bracket and could withdraw funds from this account without paying taxes. The only rule after this is that you need to begin making distributions before you turn 72.

Tax Bracket Considerations

One of the key factors to consider when deciding to choose a Roth 401K, compared to a regular 401K plan, is what income tax bracket you anticipate that you will be in. A Roth 401 K plan is best for younger employees who expect to be in a higher tax bracket in the future, as they can make post-tax contributions while they are in a lower income tax bracket, and then focus more on traditional 401K plans later in their career when they are in a higher tax bracket.

However, it can be difficult for most people to predict life and career changes like this. Moreover, most companies are extremely flexible and will allow employers to choose a combination of both plans. Another benefit of diversifying like this will come along later in life when you are able to withdraw funds from your Roth IRA without paying taxes while you are in a higher income tax bracket, and then waiting to withdraw more funds from your traditional IRA accounts when you are in a lower tax bracket.

Roth IRA

The Roth IRA is a retirement investment account that allows individuals to enjoy tax-free capital gains and dividends and withdraw funds without paying any taxes when they retire. The rules for Roth IRA accounts are similar to that of Roth 401 K accounts in many areas, including the 5-year withdrawal rule and rules regarding taxes. However, there are several key differences between Roth IRA and Roth 401 K accounts to consider before deciding whether to open one or both of these retirement accounts.

Factors to Consider

Lower Contribution Limits: The contribution limit for Roth IRA is much lower, relative to employer-sponsored Roth 401K IRA plans. The current limit is $6,500/year, and this amount is $7,500/year if you are 50 years or older. Therefore, it is best to open a Roth IRA as early as possible to take advantage of tax-free capital gains.

Income restrictions: Another notable difference is that not everyone is eligible to open a Roth IRA account. If your annual income exceeds $138,000, then you are not eligible to fund a Roth IRA account. In this case, it is best to see if you can open a Roth 401K IRA.

More flexibility: One superior factor about Roth IRAs is that you generally have more flexibility when withdrawing funds, as you have already paid taxes on your income before funding your account. However, you need to make sure that you wait 5 years before doing so.

No taxes when retiring: Finally, Roth IRAs are similar to Roth 401K in the fact that you do not need to pay income taxes on any distributions made after you turn 59.5 years old.

Self-Employed: Roth IRAs are wonderful options for people who are self-employed, and are not able to participate in company-sponsored 401k plans.

Backdoor Roth IRA

A backdoor Roth IRA allows you to convert your traditional IRA to a Roth IRA. This is a solid option for higher-income investors who can’t directly fund their Roth IRAs because of their higher income. To do this, you will need to transfer funds from your already-established IRA to your newly-established Roth IRA. Before doing this, you will need to pay taxes on the money you have in your IRA account, before transferring it to your Roth IRA account. Investors can also plan to do this at a time when they are in a relatively lower tax bracket so that they can minimize their income taxes.

List of Exceptions for Both Plans

401K Plans: Certain factors like death and disability will allow you to make qualified distributions from your qualified 401 K plan. However, there are other common expenses, like education expenses, medical expenses, and purchasing a home, that are not qualified distributions. Roth 401K accounts are still subject to early withdrawal penalties and income taxes, even though you already pay taxes on the account before taking money out. The 10% penalty is applied to some, but not all of the money that you take out, and this amount is based on your earnings ratio.

Roth IRA Plans: Some plans have more flexibility, as expenses like purchasing a home ( up to $10,000) and eligible education expenses count as qualified distributions. The benefit of a Roth IRA is that you have more flexibility when deciding to withdraw funds, as education and new home expenses count as qualified withdrawals. Since you already paid taxes on your contributions, you do not have to pay taxes or penalties on these if you withdraw the funds early. However, you will need to pay a 10% penalty and income tax on the earnings if you make a non-qualified distribution.

Example: If you have a Roth IRA balance of $100,000, and $90,000 of this includes your contributions and $10,000 includes earnings, then you will pay taxes and penalties on the 10% portion for non-qualified distributions. For example, if you withdraw $20,000, then you will have to pay taxes and penalties on $2,000 of this amount.

You will likely need to get supporting information from your plan sponsor if you decide to withdraw funds from your account early due to things like hardships or disability.

The five-year rule applies to anyone who opens a Roth IRA and states that distributions made before the first five years are not qualified. Some people who fund a Roth IRA too late will have to wait until they are in their 60s to make qualified distributions.

Example: If you decide to open a Roth IRA when you are 57 years old, for example, you would still need to wait until you were 62 years, not 59.5 years old.

Using Your Roth IRA for a Loan

If you need access to emergency funds and want to avoid an early withdrawal penalty, you can always choose to borrow funds from your 401k account. According to the current IRS rules, you will have to pay interest on this loan and incur a penalty if you do not pay the loan back in five years. The amount that you can borrow is the lesser of 50% of your portfolio or $50,000. It is also crucial to keep in mind that you will have to pay your loan back faster if you change jobs and use your Roth 401K account. While this can be a great option, which allows you to avoid penalties, you should still note that removing these funds from your retirement account delays the compounding process and will technically lower the amount you have when you retire.

Self-directed IRA

Self-directed Roth IRA accounts can be a solid option for you if you want to invest your retirement funds in certain types of alternative investments. This type of account allows investors to invest in investments like precious metals, cryptocurrency, commodities, private placement securities, and other types of alternative assets not available through traditional IRA accounts. Investors who choose to go this route should be mindful of the higher risks typically found in these areas, as some of these products are more volatile and can have lower liquidity.

Final Thoughts

Anyone who is eligible for a Roth IRA account, including a traditional Roth IRA and Roth 401K account, should choose to go this route, especially if they anticipate that they will be in a higher income tax bracket in the future. Roth IRA accounts are excellent retirement products, especially for younger investors, and can allow you to avoid paying taxes on distributions once you retire.

Moreover, having both a Roth IRA account and a traditional IRA account can also help you in the future when your income tax bracket changes. Doing this can allow you to withdraw funds from your traditional IRA accounts in earlier years while relying on the Roth IRA accounts when you are in a higher income tax bracket.

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This post was written by Sean Allaband

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