When it comes to investing for retirement you have a multitude of options to choose from. Making the decision about how you are going to manage the taxation of your retirement plan contributions makes the decision even more complex. Do you open an IRA (and should it be traditional or Roth) or invest in your employer’s retirement plan? What if your employer’s plan offers Roth as an option? Which is best? The truth is there is no one-size-fits-all answer and it depends on your own personal circumstances.

One of the most important aspects before deciding what option is right for you is to first understand the differences. A Roth IRA is an individual retirement account that you can set up with a wide variety of financial institutions and is funded with after-tax after-tax dollars allowed to grow tax-free and withdrawn tax-free, provided certain requirements are met.

A Roth 401(k) is an employer sponsored retirement account that allows you to designate after-tax money from each paycheck to be invested in your retirement account. Investment options are limited to the funds made available in the plan. Not every employer offers the option of Roth and if the option is available to you, you are also allowed to contribute pre-tax and make both contribution types at the same time. It is important to note that employers can choose to match an employee’s contributions and those contributions are made pre-tax. Thus, when an employee contributes Roth and receives an employer matching contribution the result is two “buckets” of money, one pre-tax and one after-tax.

Key Differences

  • Roth IRAs come with an income limit while Roth 401(k)s don’t.
    • In 2023 any individual taxpayer with an adjusted gross income (AGI) over $153,000 or married couple filing jointly with an income over $228,000 are not eligible for a Roth IRA.
  • A big advantage of Roth 401(k) is the annual contribution limit. In 2023 you can contribute up to $22,500 if you are age 49 and younger and $30,000 if you are age 50 and older. In a Roth IRA the current limits are $6,500 and $7,500 based upon your age.
  • Until the year 2024 and after, Roth 401(k) requires a minimum distribution (RMD) if you are age 73 or older while a Roth IRA does not.
  • If you withdraw from a Roth 401(k) before the age of 59½, which should always be a last resort, you are subject to a 10% penalty. In a Roth IRA you can withdraw contributions without penalty, though earnings are subject to a 10% penalty if withdrawn before age 59½.

Roth Taxation and What to Know

In general, when you are contributing income to a retirement account you will incur income taxes. The Roth option allows you to pay your income taxes on your contributions when they go into your account rather than paying the taxes at the time of withdrawal. It is important to recognize if you are a high-income earner and contributing Roth dollars, you are paying taxes on your contributions at a higher rate than you may be in the future once you are in retirement and living off less income. But here’s a key consideration: with both accounts, investment earnings are not taxed with a qualified withdrawal. This can mean a large nest egg of tax-free earnings when you retire, particularly if you’ve accumulated tax-free earnings for a long period of time. A qualified withdrawal means that you take a cash distribution from your Roth account after age 59½ and the account has been open for at least five years, or you become disabled or deceased.

With a Roth IRA, you can withdraw your contributions prior to age 59½ without tax or penalty but any earnings portion withdrawn would be taxed and a penalty incurred, with a few exceptions. The same tax circumstance exists with Roth 401(k) withdrawals, but you must be qualified to take a withdrawal from your employer’s plan. Additionally, there are no exceptions to earnings being taxed unless you are taking a loan from your Roth 401(k). This option is only offered in some employer retirement plans and the earnings will be taxed and penalized if you fail to pay the loan back.

Choosing Between a Roth 401(k) and Roth IRA

When it comes to choosing between the two types of investment vehicles, you don’t have to. You are allowed to have both a 401(k) and an IRA and contribute the annual limit to both account types if you are financially able.

A Roth 401(k) is a Great Choice if You:

  • earn too much money to contribute to a roth ira and want to accumulate after-tax dollars for your retirement.
  • want to take advantage of an employer match and accumulate after-tax dollars.
  • want to contribute as much after-tax money as possible.
  • prefer the ease of having contributions automatically deducted from your pay and streamlined, well-researched investment options.

A Roth IRA is a Great Choice if You:

  • want to be able to withdraw contributions tax and penalty free before you turn age 59½.
  • want a wider array of investment options to choose from.
  • don’t have a Roth contribution option in your employer’s retirement plan.

The bottom line when comparing a Roth IRA with a Roth 401(k) is to understand each has its own perks. The most important aspect of reaching a healthy retirement is to invest, whether it be in your own individual retirement account or through an employer. For many people it may be useful to capitalize on the benefits of both types of accounts. If an employer offers a matching contribution, it is always wise to contribute to the plan to take advantage of “free” money even if you prefer to contribute to your own individual retirement account.