Roth 401k & Roth IRA: Tax-free retirement funds

When it comes to your retirement, a Roth 401k and a Roth IRA are both funded with post-tax dollars. The money you put into them is taxed at the time you contribute. That’s the opposite of a traditional 401k and IRA, which defer income tax on their contributions. When it comes time to withdraw money from either Roth account – it’s tax-free.

Pull out 100,000 from a Roth retirement account – you owe the IRS nothing. Do the same with a traditional retirement account – you owe income taxes on it. Roth accounts are very popular for just that reason. Pay the income tax in small amounts over time and get a huge tax-free pool of money when you retire.

Which is Best – Roth 401k or Roth IRA?

Both accounts have advantages and limitations. It’s not really an either-or situation. Here’s how each of the accounts work.

Roth 401k

The first issue you may have with a Roth 401k is availability. Though they are becoming more mainstream, not every employer offers one. Larger corporations are more likely to offer the option than mid-market or small businesses. They can have some additional administrative requirements.

If you can sign up for a plan at your job, the contribution limits are the same as a traditional 401k does. In 2021, you can contribute  $19,500 or $26,000 if you’re over 50. The major difference is the post-tax dollars that fund your account. The investments in your portfolio grow tax-free.

If your company offers a match, be aware that your employer’s contributions are taxable. The company designates the contribution amount to your Roth 401k but store the money separately in a traditional 401k account. It’s more complicated on the employer end but keeps the taxable amounts straight for the employee.

You become eligible to withdraw money without a penalty from your Roth 401k when you reach the age of 59 1/2. The one difference from a traditional plan, a Roth 401k needs to be operational for 5 years before you can withdraw without penalty. There are other exceptions to the rule – if you become disabled or if you inherit the account.

Once you put your money in a Roth 401k, you can’t switch back to a traditional 401k. On the flip side, you can convert a traditional to a Roth 401k. But you have to pay taxes on the money you withdraw. It’s not a tax-free transfer.

Roth IRA

The Roth Individual Retirement Account works on the same principle as a Roth 401k plan. Contributions to the account are not tax-deferred. The Roth IRA does not reduce your Adjusted Gross Income like a traditional IRA. But they both have the same contribution limit – $6000 per year, $7000 if you are over 50. Contributions can be made by the account owner, a spouse, fund transfer, or a rollover. You can only contribute earned income – no capital gains.

The investments in a Roth IRA grow tax-free, unlike a traditional IRA. But there are some differences worth noting. Roth IRAs are not available to everyone. There are income limitations to be eligible. In 2021, married filing jointly, your income must be less than $198,000 to be fully eligible. A single person, filing as head of household, must have an income lower than $125,000.

Both married and single taxpayers have options for partial eligibility. The IRS provides a calculation to determine how much you can contribute. Married taxpayers filing separately have very limited options.

Withdrawals are a Roth IRA differentiator. Not only are they tax-free, but they are considered qualified distribution. You can make withdrawals of your contributions without any age requirements. But the earnings on your investments have different requirements. First, the Roth IRA must be held for at least 5 years.

It’s called the 5-year rule. If you are over 59 1/2 and meet the 5 years – you withdraw earnings tax-free. Under that age, you pay tax on the earnings and a 10% penalty. If you don’t meet the 5-year rule and are under 59 1/2, you pay taxes and the 10% penalty. Over 59 1/2, you pay the tax without the penalty.

There are some exceptions to the rules. When you have medical expenses, need to pay for health insurance,  become disabled or inherit the account. Also remember, these restrictions apply only to earnings from investments in your account. If you paid $6000 in the current year, you can withdraw it anytime you want.

Read: (Complete How-To: Backdoor a Roth IRA in 2021)

Which Roth Retirement Account Suits You?

This is the better question to ask. Both Roth accounts have similarities but also some differences. Compare your options below.

  • Contributions limits are much higher for a Roth 401k. If you have the option for an employer Roth 401k, it makes sense to consider it. You can build your retirement fund much faster. Best long-term if you don’t need the income tax deduction now.
  • Contributions to a Roth IRA are liquid. You can withdraw the amount you contributed, without tax or penalty. To withdraw earnings on your account is more complicated. There are restrictions based on age and the 5-year rule. Good if you think you’ll need access to cash.
  • Not all employers offer a Roth 401k but there are no income requirements if they do. If you work for yourself – with no employees – you can buy into a Roth 401k plan. Good if you’re self-employed.
  • There are income eligibility requirements for a Roth IRA. Wealthier taxpayers (annual income over $220k) are prohibited from opening an account. Good if you follow the rules
  • Both you and your spouse can have a separate Roth IRA. This doubles the amount of the family’s retirement account. Good if you stay married and continue filing jointly.
  • Your spouse can contribute to your Roth IRA. Contribution limits still apply and must file jointly. Helpful if one spouse has the income to fund the other’s IRA.
  • Only you and your employer can contribute to your Roth 401k. An employer match is considered separate from your contributions. Free money on top of maximum contribution limits.

Can you have both?

Yes. You can have a Roth 401k at work and a Roth IRA at the same time. The big advantage of Roth retirement accounts is the tax-free payout later in life. If your Roth 401k has a value of $975,000 when you turn 60, you can pull out any amount tax-free. If you need $150,000 to invest in real estate – just get it. Add another $200,000 from your Roth IRA – you have over a million dollars in liquid capital.

If a 60-year-old withdraws the same $150,000 from a traditional IRA, it’s taxed as income in your current tax bracket.

The possible disadvantage of Roth retirement accounts is that contributions are taxed in the year that they’re made. Depending on your income, it could push you into a higher tax bracket. Talk with a tax professional about your liability. An IRA can be opened and funded up until April 15th of the current tax year (May 17th in 2021.) Take a look before you file to see if you can fund the Roth IRA without issue.

Make sure you can afford to fund both accounts. If not, it might make sense to fully fund your 401k first. Remember too, that you can only fund a Roth IRA if you meet the income requirements.

Setting Up Roth IRAs

Some employers may offer a Roth IRA as part of the benefit package, but most don’t. You can open a Roth IRA on your own as long as you meet the income requirements. You need an account with a broker to get started.

When you’re choosing a broker, decide what type of role you want to play. You can actively choose stocks and assets to invest in or you use a robo-advisor. If you prefer to pick your stocks, just go to a brokerage and open an account. Here’s a list of online brokers with the best Roth IRA accounts.

If you’re looking at the IRA as a passive-income stream, choose a robo-advisor. The portfolio decisions are based on an algorithm. Investors monitor their portfolio via reports. The portfolio is balanced as needed. This is a list of robo-advisors.

If you’ve chosen to manage your portfolio yourself, it’s time to choose your investments. (Skip this step if you choose a robo-advisor.) An index fund may be a good place to start. It helps to keep your portfolio diversified. Index funds include mutual funds and EFTs. You can buy individual stocks or other assets as well.

Remember, you fund the account from earned income, up to the maximum annual limit. Then you choose the assets. The other issue with managed accounts – the fees are typically much higher than a robo-advisor.

Set up Your own Roth 401k

A solo Roth 401k plan is for the self-employed who have no employees. The only exception is for your spouse – if it’s a mom-and-pop business. If freelance or have a consulting company, it’s worth your while but it can be complicated to set up.

Not all brokers who sell 401k plans offer a Roth 401k. The Roth is typically an add-on to the plan. As the account owner, you wear two hats – employer and employee. You as the employee make contributions and you as the employer can make an employer deferral (i.e., a match.)

Here’s how it works.

 Summing up a Roth 401k and a Roth IRA

All Roth retirement plans are funded with post-tax dollars. You pay tax on the contributions when you make them. For that reason, when you withdraw money from your account – it’s tax-free.

The Roth 401k is becoming more mainstream in employee benefit packages. It’s renowned for tax-free investment capital after retirement. The issue is whether or not you can afford the taxes now. If you max out your contributions, that’s $19,500 worth of income you leave on your taxes. But if you can afford to take the hit now, you end up with a serious chunk of tax-free cash.

A Roth IRA is easily available but comes with more requirements. There are the income constraints on eligibility and also the earned income requirement. That means you can’t use money from dividends or capital gains or stock sales to fund your Roth IRA.

You can set up a Roth IRA with any brokerage. Set yourself up with a robo-advisor that handles the portfolio or take a more active approach. No matter which one you choose, you can withdraw your contributions at any time, tax-free. But the earnings from your portfolio are taxable unless your account has been open for 5 years and you’re over 59 1/2.

Mix and Match

You can consider mixing a traditional retirement account with a Roth account. It might make sense to open a traditional IRA when you have a Roth 401k. It would offset your tax liability by 6 or 7 thousand dollars if you max out the contributions.

Traditional IRAs do not have income restrictions like a Roth, but they aren’t as liquid either. You can’t pull money out until you hit 59 1/2. And then you have to pay the tax you deferred. If you’re retired, your tax bracket may be lower than when you opened your account. On the positive side, your retirement account is more likely to stay whole until you retire. On the not-so-positive side – it’s your money.

The real issue isn’t choosing between Roth retirement plans. It’s deciding between Roth plans and traditional plans. Do you want to pay taxes now or pay them later?

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