Adding a Roth account to your retirement plan can be a great money-saving strategy. The benefits of setting up a Roth IRA are well documented, but did you know that there are Roth versions of employer-sponsored 401(k), 403(b), and 457 retirement plans?

In recent years, it’s become more common for both public and private companies to give their employees the option to use Roth versions of their retirement plans. While these Roth employer plans share much in common with Roth IRAs, there are important differences between the two that you need to be aware of.

Similarities Between Roth IRAs and Roth Employer Plans

Neither Roth account benefits from an income tax deduction on contributions made into the account. This is a significant difference from traditional tax-sheltered retirement plans where contributions are income tax-deductible, typically in the year in which they are made.

In both Roth IRA and Roth retirement plans, all appreciation, interest and dividends accumulate on a tax-deferred basis, as long as the assets are not withdrawn from the account.

Additionally, Roth plans give you the ability to draw tax-free income in retirement, provided you meet two conditions:

  1. You are at least age 59 ½
  2. You participated in the plan for a minimum of five years prior to taking distributions

Finally, if withdrawals are taken from Roth accounts prior to age 59 ½ or within five years of original contribution, only the earnings are subject to ordinary income tax and a 10% early withdrawal penalty. The contributions themselves carry no tax or penalty.

Differences Between Roth IRAs and Roth Employer Plans

Despite the similarities mentioned above, Roth IRAs and Roth employer plans differ in a number of ways. Here are five of them:

1. Eligibility Requirements

In 2021, if you’re a single tax filer and your modified adjusted gross income (AGI) is equal to or greater than $125,000 ($198,000 if married and filing jointly), then the amount you can contribute to a Roth IRA begins to phase out. If your modified AGI is equal to or greater than $140,000 ($208,000 if filing jointly), then you cannot contribute at all.

There may be ways to contribute to a Roth IRA even if you exceed the income limits, but this typically depends on factors that include your tax status and the presence or absence of other IRA accounts in your name.

Meanwhile, there are no income limits for Roth employer-sponsored retirement plans. Eligibility is determined by your employer’s plan documents.

2. Annual Contribution Limits

In 2021, the Roth IRA annual contribution limit is $6,000 for individuals younger than 50 years of age. If you’re 50 or older, you can contribute an extra $1,000 per year in "catch-up" contributions, bringing the total contribution to $7,000.

Roth employer plan participants can save a much larger amount than they can using a Roth IRA. The 2021 contribution limit for 401(k), 403(b), and 457 accounts is $19,500 for employees under age 50, but employees 50 and older can contribute an extra $6,500 in catch-up funds—bringing the total amount you can contribute up to $26,000. As long as your income doesn’t exceed the Roth IRA limits mentioned above, you may use both a Roth employer plan and a Roth IRA.

3. Plan Limitations

When you withdraw funds from your Roth IRA account prior to age 59 ½ or before you’ve had your account for five years, you are allowed to take your contributions out first. For example, if you have a $20,000 Roth IRA with equal parts earnings and contributions, you could withdraw up to $10,000 early before being subjected to taxation and the early withdrawal penalty.

It may be more difficult—or impossible—to take an early withdrawal from your Roth employer plan than from your Roth IRA account. Roth employer plans may impose restrictions to access that limit or preclude early, pre-59 ½ withdrawals. Even in plans where early withdrawals are allowed, the IRS treats the distributions differently. From a Roth employer plan, you must take contributions and earnings on a pro-rata basis. Using the above example for the same $10,000 withdrawal, only $5,000 would be treated as a tax- and penalty-free return of contribution, and the remaining $5,000 would be subject to the early withdrawal tax and penalty.

4. Required Minimum Distributions

Required minimum distributions (RMDs) are forced distributions from retirement accounts that begin when individuals reach age 72. The amount of these mandatory withdrawals changes each year based upon your age, regardless if you need the income or not.

Roth IRAs are not subject to RMDs, and therefore the entire amount continues to grow on a tax-protected basis. If you do not need the income, it can continue to accumulate for the benefit of your heirs or a late-life emergency fund.

Roth employer plans, however, are subject to these withdrawals. While you do not have to pay income taxes on the distribution from a Roth retirement plan, you no longer benefit from the tax-free growth of the amount distributed. It is important to note that, depending on your Roth employer plan, you may be eligible to transfer or roll over the plan into a Roth IRA account that would not be subject to RMDs.

5. Investments Available

Under a Roth IRA, you have considerable freedom in selecting both the company you set up the account with and the investments you make within the Roth IRA. This allows you to shop around for what is most important to you, such as a low-fee account with access to thousands of investments, including Exchange Traded Funds (ETFs) or individual stocks.

Under a Roth employer plan, you may have little-to-no say over the investment company and are often limited to the investment options selected by the employer.

Which Roth Is Right for Me?

When looking at your options between a Roth IRA, a Roth employer plan, or both, it will be important to understand your employer’s plan, your income level, your investment objectives, your current savings, and whether any Roth accounts make financial sense as part of your total circumstances. Having a future-focused financial plan will help you get the most out of your selected strategy.

Luckily, you don’t have to make that decision alone. Speak with a qualified financial advisor to find out whether a Roth IRA, Roth retirement plan, or both is a smart strategy for you.

 

All information herein has been prepared solely for informational purposes only and opinions are subject to change. Past performance is not indicative of future results and all investments involve the risk of loss of principle. For information on how these general principles apply to your situation, consult an investment professional.

Brett Christensen

Brett Christensen

Financial Advisor

CFP®, JD, Series 65 Advisory Registration† Brett’s client-centric approach to planning focuses on education, advocacy, and coordination of individuals’ goals for themselves and their families. Brett has worked extensively on an individual basis with university professionals. This group includes professors, deans, and provosts at campuses across the United States. He is a CERTIFIED FINANCIAL PLANNER™ and a member of the Wisconsin Bar Association. Some of his areas of...Read More