You know, of course, what a 401(k) is and what an IRA is. But ever since the Roth versions of these tax-advantaged vehicles came on to the scene (doubling the options), allocating retirement-planning dollars has gotten more complicated. Here’s the lowdown on both Roths. The good news is that, unlike the Roth IRA/traditional IRA relationship, the Roth 401(k) functions nearly identically to the traditional 401(k) as far as contributions go.
- Roth retirement accounts allow savers to grow their money income-tax-free by using after-tax dollars.
- Roth 401(k) plans are offered through employers, and are similar in many ways to a traditional 401(k) but do not use pre-tax funds.
- Roth IRAs are set up on an individual basis and are subject to similar rules and contribution limits as traditional IRAs.
The Roth 401(k) officially entered the retirement investment space in 2006. This innovation in employer-sponsored investment accounts was created by a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001.
Modeled after the Roth IRA, the Roth 401(k) provides investors an opportunity to save retirement funds in a tax-advantaged account. As with a regular 401(k), the deposits can be taken directly out of the individual’s paycheck. Unlike its traditional counterpart, however, the Roth 401(k) account is funded with after-tax dollars (as opposed to pre-tax dollars). That means no tax deduction is received on contributions to a Roth 401(k), and —but also that investors will owe no taxes on qualified distributions.
Participants in 403(b) plans are also eligible to participate in a Roth account.
Offering the Roth 401(k) is voluntary for employers. To offer such a plan, employers must have a traditional 401(k) plan in place, and they must set up a tracking system to segregate Roth assets from those of traditional 401(k) assets. This may be an expensive proposition, and your employer may choose not to do it.
Employers can match contributions to Roth 401(k)s; in fact, if an employer matches a traditional 401(k) plan contribution, it is standard for it to match one for a Roth 401(k). But—unlike the employee’s contribution—the employer’s contribution is placed into a traditional 401(k) plan. So it is taxable upon withdrawal.
Percentage of 401(k) plans that have a Roth option in 2021, according to a Fidelity Investments study
Named after Delaware Senator William Roth, and established by the Taxpayer Relief Act of 1997, a Roth IRA is an individual retirement plan (a type of qualified retirement plan) that bears many similarities to the traditional IRA. The biggest distinction between the two is how they’re taxed.
Traditional IRA contributions are generally made with pre-tax dollars; you usually get a tax deduction on your contribution and pay income tax when you withdraw the money from the account during retirement.
Conversely, Roth IRAs are funded with after-tax dollars; the contributions are not tax-deductible—although you may be able to take a Saver’s Tax Credit of 10% to 50% of the contribution, depending on your income and life situation. But once you start withdrawing funds, qualified distributions are tax-free.
Roth IRAs are voluntary and must be set up on an individual basis, rather than through an employer.
You can contribute a maximum of $19,500 in 2020 and 2021 to a Roth 401(k)—the same amount as a traditional 401(k). If you’re aged 50 or older, you can contribute an extra $6,500 as a catch-up contribution. These limits are per individual; you don’t have to consider whether you’re married or single.
If you want to contribute to both a Roth and a traditional 401(k), the maximum amount is still $19,500. You can split your contributions between the accounts in any way you like.
You can contribute up to $6,000 annually to a Roth IRA in 2020 and 2021—and if you’re 50 or older, you get to put in an extra $1,000, bumping the total to $7,000.
One financial strategy, for those who want the max in tax-advantaged savings: open both types of Roth accounts. Between the two, you can invest up to $25,500 in 2020 and 2021 ($19,500 in the 401(k), $6,000 in the IRA)—or even more, if you’ve hit the age-50 threshold by year’s end.
With Roth IRAs, there are limits to what you can contribute (or even whether you can participate in one at all), based on your income. Generally, the higher it is, the more restricted your contributions.
However, the Roth 401(k) has no income limit; your income isn’t even considered. That means you don’t have to worry about your ability to contribute to a Roth account phasing out as you make more money.
Overall contributions to a Roth 401(k) can’t exceed your compensation, of course. For 2021, the combined total of employee and employer contributions cannot exceed the lower of $58,000 or 100% of the employee’s pay ($64,500 if you’re aged 50 or older).
To have both a Roth IRA and Roth 401(k), you must be within the allowable income range for a Roth IRA.
For 2021, the income phase-out for contributing to a Roth IRA starts at $126,500 for individual tax filers. Individual eligibility ends at $140,000. For taxpayers who are married filing jointly, as well as qualifying widowers, the income phase-out for 2021 starts at $199,000 and ends at $208,000.
If you are getting a new job, you might be considering rolling over the Roth 401(k) into a new account.
You’ll be glad to know that when it comes to rollovers, there is no contribution limit; you can transfer whatever is in your account. Just be sure to have the old account’s trustee or manager directly roll over to the entity managing the new one (or, at the very least, have the check made to the new manager as the account trustee, not to you personally). That way, you avoid any possible adverse tax consequences. Also, be sure you’re rolling over from a Roth to a Roth.
The Bottom Line
Contribution limits on all tax-advantaged accounts are indexed to inflation. This means the IRS routinely re-evaluates the maximum amount you can contribute by comparing it to the overall health of the economy.
If you’re in a financial position where you’re contributing near the maximum allowed, be sure you stay up to date by checking the IRS tables for Roth IRAs and Roth 401(k)s or asking your plan administrator about the current limits.