Tale of the Tape: Comparing Roth IRAs and Roth 401(k)s

By Ian Berger

Concerns about possible future tax increases have fueled the continuing increased popularity of both Roth IRA and Roth 401(k) accounts. Roth accounts can be offered in 401(k), 403(b) or governmental 457(b) plans. So, references to “Roth 401(k)” in this article will mean Roth accounts in any of those plans.

Clients who meet certain income restrictions can make 2021 Roth IRA contributions of up to $6,000, or $7,000 if age 50 or older. Roth contributions are optional for company plans, but more and more plans are offering them. Employees with a Roth 401(k) option can make contributions of up to $19,500 in 2021, or $26,000 if age 50 or older. (Note that the $19,500/$26,000 limits cover combined Roth 401(k)s and pre-tax elective deferrals.)

Contributing to a Roth 401(k) does not affect a client’s ability to contribute to a Roth IRA – and vice-versa. This means someone over age 50 could potentially contribute as much as $33,000 ($7,000 + $26,000) between a Roth IRA and a Roth 401(k) this year.

But what if a client lacks the funds to contribute to both a Roth IRA and a Roth 401(k)? Which is a better strategy? In analyzing this question, advisers should be aware of the advantages each option has to offer.

Why a Roth IRA May Be Better

More investment options. There is only a short list of investments listed in the tax code that Roth IRAs cannot be invested in: collectibles (except for certain coins minted by the U.S. Treasury), life insurance and S corporation stock. All other types of IRA investments are allowed. By contrast, Roth 401(k)s are limited to the options offered by the plan.

No RMDs. Required minimum distributions (RMDs) are not required for either Roth IRA owners or surviving spouses who roll over an inherited Roth IRA to their own Roth IRA. On the other hand, all Roth 401(k) participants and beneficiaries are subject to RMDs. (However, participants still working at age 72 may be able to delay their first RMD until after they retire.)

Qualified distributions. In order for earnings on either a Roth IRA or Roth 401(k) to be withdrawn tax-free, the distribution must be considered “qualified.” A qualified distribution requires a triggering event and satisfaction of a five-year holding period (also known as a “five-year clock”). For both Roth IRA and Roth 401(k)-qualified distributions, triggering events are attainment of age 59½, death or disability. For Roth IRA-qualified distributions [but not Roth 401(k)s], a first-time home purchase is also a triggering event.

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There is also a difference in the way the five-year clock works for plans and IRAs. For Roth IRA distributions, the clock is satisfied if the IRA owner opened ANY Roth IRA within the last five years. (Technically, the five-year period starts on Jan. 1 of the year of the first Roth IRA contribution or conversion.) The Roth IRA that received the initial contribution or conversion and started the clock does not have to be the same Roth IRA now being distributed.

However, for a Roth 401(k), the five-year clock is computed on a plan-by-plan basis. In other words, the participant receiving a distribution must have started making Roth contributions to that plan at least five years ago. This means employees with Roth 401(k) dollars in separate plans have separate clocks.

Non-qualified distributions. When a Roth IRA distribution is not qualified, favorable ordering rules apply. The first distributions made are considered to be contributions, up to the amount of contributions made – no matter where the distributions actually come from. This is good news because Roth IRA contributions always come out tax and penalty-free. The next distributions are considered to be conversions, which are always tax-free but may be subject to penalty. Only then are earnings, which are taxable and possibly subject to penalty, considered to be distributed. The result is that in many cases, even a client’s non-qualified Roth IRA distribution will be tax-free.

When a Roth 401(k) distribution is not qualified, the less favorable pro-rata rule applies, usually resulting in a portion of the distribution becoming taxable. The taxable portion is the amount of the distribution multiplied by the taxable fraction. That fraction is the amount of earnings in the Roth 401(k) account divided by the total Roth account balance.

Accessibility. Roth IRAs can be withdrawn at any time. Not so with Roth 401(k)s, which are not available for in-service withdrawal before age 59 ½ (except in the case of hardship).

Why a Roth 401(k) May Be Better

No income limits. There are no income restrictions for Roth 401(k) contributions. By contrast, Roth IRA contributions cannot be made directly if modified adjusted gross income exceeds a certain dollar limit (for 2021, $208,000 for married couples filing jointly, or $140,000 for single filers). Clients whose income is too high can make indirect Roth IRA contributions through the “Backdoor Roth IRA” by first making nondeductible traditional IRA contributions (which have no income restrictions) and then converting them to Roth IRAs. However, the pro-rata rule adds a layer of complexity to this strategy.

Creditor protection. If a client’s Roth 401(k) is covered by ERISA, it enjoys rock-solid protection against bankruptcy creditors and non-bankruptcy lawsuits, like malpractice actions. Most 401(k) plans, with the exception of the Thrift Savings Plan and solo 401(k) plans, are ERISA plans. By contrast, Roth IRAs only receive the creditor protection available under state law. State law creditor protection varies and can be weaker than ERISA protection.

10% early distribution penalty. For clients under age 59½, earnings on non-qualified Roth IRA distributions may be subject to a 10% penalty. But Roth 401(k) distributions made after separation from service are not subject to penalty if separation occurs in the year the participant reaches age 55 or older.

Loans and life insurance. Many 401(k) plans permit participants to borrow against their accounts. Roth IRAs cannot offer loans. Similarly, some 401(k) plans allow investments in life insurance, but that is not allowed with Roth IRAs.

Matching contributions. Many 401(k) plans match Roth 401(k) contributions, which is like free money for participants. There is no comparable bonus for making Roth IRA contributions.

For clients looking to protect against the possibility of future tax hikes, a Roth IRA or Roth 401(k) is a great choice. Often, however, clients lack the funds to maximize both options. Deciding which Roth account to fund is not a one-size-fits-all evaluation. Advisers must be equipped to assess which Roth option makes the most sense given the client’s particular situation.

About the author: Ian Berger, J.D., is an IRA Analyst with Ed Slott and Company, LLC with over 30 years of experience with retirement plan and IRA issues working in both the private and public sectors. Get more information on Ed Slott and Company’s Virtual 2-Day IRA Workshop, Instant IRA Success. Plus, See Slott’s updated and No. 1 new book, “The New Retirement Savings Time Bomb.” Click here to receive Ed Slott and Co.’s monthly IRA Updates eNewsletter, featuring important breaking news and trending topics in the IRA world.