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Differences Between Roth IRA and Roth 401k

The first difference that comes to mind when comparing Roth IRA to a Roth 401k is the contribution amounts. For the Roth IRA you can contribute up to $5,000 to your plan and for workers over 50 may contribute an additional $1,000 per year (i.e. $6,000/yr total). The Roth 401k plan has higher contribution limits, allowing employees to save up to $16,500 per year. For workers over 50, the limit is $22,000. Therefore, the contribution limits for a 401(k) are roughly three times higher than that of an IRA. For the Roth 401k plans, the contribution limits are the same as the traditional 401k limits, so this is a definite benefit.

The next big benefit is the income limits. The higher earners can convert to a Roth IRA from a traditional IRA, but they won’t be able to make contributions if they make over a certain income (see my prior blog post for details). Not so for a Roth 401k, in which there are no such restrictions. For example, Roth IRA contributions are off-limits if your modified adjusted gross income in 2011 is higher than $179,000 for married couples filing jointly or $122,000 for single filers. So for some people the Roth 401k is the only way to go or forfeit any government sponsored savings plan.

A nice benefit and advantage to a Roth IRA is that you don’t have to take distributions and essentially the account can exits forever without taking out any of the money. No RMD (required minimum distributions). The Roth IRA can be passed down to the next generation and provide tax-free earnings for that generation and the next. A Roth 401k, on the other hand, will require minimum distributions (RMD) starting at age 70½. If you need the money, you may not mind taking the distributions. But there is a way around it if you prefer to keep your savings working for you tax-free. You could roll the account over from a 401k directly to a Roth IRA but you would pay tax on any portion that was not Roth dollars.

On the flip side, an advantage of the Roth 401k is that the worker’s contributions can be matched by the employer up to a certain percentage. It’s essentially free money from the employer, on top of the employee’s elective deferrals. Just remember that the match portion of the contribution will be treated as a traditional 401k contribution since it goes in as pretax dollars. This is because the employer contribution can’t be taxed and in turn can’t be a Roth contribution. In other words, every Roth 401k has a Roth portion and a Traditional portion depending on where the dollars are coming from and what you elect.

If not in a self directed IRA or solo 401k plan that specifically allows alternative investments, your investment options would be more limited in a employer 401k since you are limited to the investment choices of that employer. On the other hand, a Roth IRA allows investors a great deal more control over their investment choices since they can choose from the wide range of investments for their own accounts. The best way to avoid the limited choices is to open a Self Directed Roth IRA or a Solo 401k Plan which essentially allows you to invest in anything allowed by the IRS. We will talk more about the Solo 401k in future blog posts.