difference between a Roth 401(k) and a Roth IRA

It’s never too early to start planning for retirement. Most people in their 30’s and 40’s may feel that they’re too young to think about it. And the Golden Years seem a long way off from where you are right now.

But it’s a good idea to be aware that time flies!

Before you know it, you’re tied up with family expenses, investments, loans and mortgages, leaving not much elbow room for financial decisions.

Individual Retirement Account

Retirement plans help you to meet expenses and have an income after you stop working. They are usually set up by insurance firms, employers, government, private and public institutions or trade unions.

If you’re employed, you could already be enrolled in a retirement plan sponsored by your employer. But an individual retirement account (IRA) provides certain extra benefits. You can save for retirement while also saving taxes and your money can grow tax-deferred.

There are several different types of IRA’s. They may be defined benefit (pension) or defined contribution (employer-sponsored) plans. Other types include hybrid and cash balance plans, qualified plans, non-qualified plans etc. and most of them provide certain tax advantages.

Two types, the Roth IRA and a Roth 401(k) provide tax benefits that are different from the majority of retirement plans. The individual’s contribution to both these plans is made by money that has already been taxed as income. When withdrawals are made, they are tax-free, provided they meet all the mandated restrictions.

These plans are different from each other in many aspects. It is important that you consult a qualified, knowledgeable and licensed expert before you begin investing in your retirement plan.

What is a Roth IRA?

Named for a senator from Delaware, William Roth, this plan, under the US law, is generally tax-free on distribution, subject to meeting certain criteria and conditions.

Instead of providing tax reductions to contributions to the plan, the Roth IRA offers qualified tax-free withdrawals from your Roth IRA plan account. This would also include growth in your account.

The account can contain investments in securities, stocks and bonds, usually through mutual funds. It can also hold derivatives, notes, real estate, deposit certificates etc. The Internal Revenue Service (IRS) does mandate certain eligibility and filing status requirements. Direct contributions can be withdrawn tax/penalty free at any point. There are conditions that apply when you acquire a residence. Your spouse becomes the sole beneficiary upon your death and assets can be passed on to your heirs. There are no minimum required distributions, so you can leave the money in the account if you want to.

However, funds cannot be used as collateral for any loans or investment purposes. Eligibility bars certain income limits so the plan may phase out at a particular income level. They work best when you anticipate that your taxes post-retirement will be higher than they are currently.

What is a Roth 401(k)

This is an employer-sponsored investment savings-account. It falls in the category of hybrid retirement plans and offers a good blend of the best of the traditional 401(k) and the Roth IRA.

It is funded by post-tax contributions up to the plan limit. It is different from the traditional 401(k) retirement plan which is funded by pre-tax contributions and attracts taxes on future withdrawals. The Roth 401(k) is a good choice for those who anticipate their post-retirement taxes to be higher than their current ones. Being a tax-advantaged plan, withdrawals within the parameters of the existing criteria are tax-free.

Comparing a Roth 401(k) and a Roth IRA

Choosing either one is based on:

  • your age
  • unique financial profile
  • your income
  • what your retirement plans are
  • when you’d like to start monetizing the plan (or whether you don’t want to)

Nearly 70% of American firms offer the Roth 401(k) plan. However, you also contribute to a Roth IRA even if you’re covered by an employer-funded Roth 401(k), provided you don’t exceed the IRS mandated income limits.

Similarities between Roth 401(k) and a Roth IRA

These two plans have many important points of similarity with each other. They share these common features:

  • No tax liability on capital gains, dividends or interest
  • Contributions are post-tax
  • Distributions can begin at age 59.5 (with some exceptions) if the account has been open for at least 5 years or owner becomes disabled
  • Allows your contribution to grow tax-free
  • Can be passed on to your beneficiaries and withdrawals are tax-free

Differences between Roth 401(k) and a Roth IRA

While the Roth 401(k) can only be set up by an employer/sole proprietor of business, the Roth IRA can be set up by individuals.

Another difference is that there are no income caps for contributions to Roth 401 (k), whereas you cannot contribute more than annual earned income to the Roth IRA plan. That’s one of the reasons why high-income earners would prefer the Roth 401(k). In the Roth 401(k) plan, matching contributions from some employers are subject to conditions, but since the Roth IRA is an individual-created plan, there are no matching contributions from the employer.

Experts also advise that there is no limit on deductible amount on the Roth 401(k), although this is subject to certain rules. However, tax-exemptions are available only up to certain income limits with the Roth IRA plan.

One of the sticking points with the Roth 401(k) is that there is a forced distribution rule that requires you to start withdrawal of funds at age 72 unless you are still employed, whereas there is no forced distribution rule in the Roth IRA.

Many investors find the loan facility with Roth 401 (k) very convenient, because up to 50% of available balance can be taken as loan, whereas no loans are available with Roth IRA. Contributions in one account can be rolled over to another employer’s Roth 401(k) or traditional IRA at another institution, whereas the funds must be transferred in the Roth IRA.

The Roth IRA allows more control over your account, but the Roth 401(k) is better for high income earners or those who want to make high contributions. On the other hand, if you want more flexibility and want to leave the account to an heir, go for the Roth IRA and it also provides easier access to your money before actual retirement.

In conclusion, remember that unless you’re a financial expert yourself, and can stay updated regularly on the changing regulations, it’s wiser to entrust the work of creating retirement plans to a pro. They can help you to remain focused on your core competencies and career while they put together the best plan for your unique financial situation.

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