Who is this for? Anyone that hopes to one day retire would benefit from understanding the difference between Roth 401ks and Roth IRAs, and how to navigate them both to your greatest advantage.
Maybe you’re here because you just started a new job and your employer offers a Roth 401(k) option. Perhaps you’re self-employed and are looking into starting your own Roth IRA. Or maybe you’re in the tech industry and keep hearing about the mega backdoor Roth 401(k).
Whatever reason you’re reading this, it’s always a good idea to plan for the future. When you hear people use terms like “traditional,” “after-tax,” “pre-tax,” and “Roth,” it’s easy to get lost and feel like it’s complicated. The reality is, it’s not that complicated once you get the terminology down and understand how each option works.
It does get a bit more complicated when you start analyzing your unique situation and goals and try to choose the best financial plan. The good news is there are plenty of professionals that can walk you through that, and help you make needed adjustments with your Roth 401(k) and Roth IRA decisions, and beyond.
In this article, we’re going to break down Roth 401(k)s, Roth IRAs, and everything related. When you’re finished, you’ll have the information you need to be an informed participant when designing your retirement plan with your financial advisor.
What does Roth Mean? Where did the Term come from? Why is it called Roth? Is Roth an Acronym?
Let’s start with the word “Roth.” The word Roth originates from Senator William Roth of Delaware. In 1989 Senator Roth teamed up with Senator Bob Packwood of Oregon. They proposed the “IRA Plus Plan” which allowed individuals to invest up to $2,000 with no tax deductions. The earnings could be later withdrawn tax-free at retirement.
The Roth IRA was eventually established by the Taxpayer Relief Act of 1997 and named after Senator Roth. In 2000, 46.3 million taxpayers held IRA accounts amounting to $2.6 trillion. Only about $77 billion was held in Roth IRAs. Seven years later the number of IRA owners jumped to 50 million with $3.3 trillion invested.
What is the Difference between a Roth 401(k) and a Roth IRA?
As we discovered above the Roth IRA came into existence in 1997. The Roth 401(k) was first available in 2001. A Roth 401(k) has higher contribution limits, and lets employers match contributions. A Roth IRA offers more investment options, and allows for easier early withdrawals.
What is a Roth 401(k)?
A Roth 401(k) account is set up by your employer for your retirement. There are no AGI (adjusted gross income) limits to contribute like there are with Roth IRAs. However, there are contribution limits. The maximum you can contribute is $19,500. If you’re older than 50 the limit is $26,000. The contribution limit counts towards both your Traditional and Roth 401(k). This means the combined total can’t be more than $19,500.
What is a Roth IRA?
Roth IRAs are set up by individuals for their retirement. Employers have nothing to do with Roth IRAs, unlike Roth 401(k)s. Individuals can only contribute to a Roth IRA if their Adjusted Gross Income (AGI) is under $196,000 – $206,000. The IRS offers a phase-out table for more information. If you’re eligible for a Roth IRA, your maximum contribution is $6,000. It’s $7,000 if you are over 50.
Roth 401(k) plans are subject to required minimum distributions. Roth IRAs are exempt. The IRS requires Roth 401(k) holders to take mandatory distributions from their account starting at age 70 and ½. The withdrawals are based on your remaining life expectancy. Roth IRAs allow you to leave your money in the account and let it continue to grow until death.
What is a Back-Door Roth IRA?
Since many individuals are not able to contribute to a Roth IRA due to the AGI phaseout explained above, an alternative strategy is the “Backdoor” Roth IRA. In this scenario an individual contributes to a traditional IRA (this likely would be a non-deductible or after-tax contribution for most people) and subsequently, and preferable immediately, converts their contribution to a Roth IRA.
Some important notes about the conversion – 1. the conversion of the contribution is not taxable if the contribution was considered after-tax and non-deductible; 2. Any growth in the contribution would be taxable at the point of conversion (therefore it makes sense to convert immediately after contribution); and 3. All IRA accounts are taken into account when determining the portion of the conversion that is taxable (so this strategy makes the most sense for people that have Uno other IRA’s).