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Roth IRA vs. Roth 401(k): Which Is Best for Your Clients?

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What You Need to Know

  • Roth IRAs have no RMD requirements while Roth 401(k)s do.
  • Unlike Roth IRAs, Roth 401(k)s have no income limitations on the ability to contribute.
  • Both types of Roth accounts can be used together to help accomplish your client’s goals.

Roth IRA, Roth 401(k) or both? This is a choice that is confusing to many retirement savers and likely to some of your clients. In some cases, the answer may be that both are a good choice. In other cases it may be one or the other, or perhaps neither if a Roth account doesn’t fit their situation and their planning needs. Here are a few things to consider. 

What Are the Benefits of a Roth IRA?

Perhaps the biggest advantage offered by a Roth IRA is that they are not subject to required minimum distributions. This can offer a number of planning opportunities for clients depending upon their situation. 

Not having to take RMDs can be a powerful tool for both retirement and estate planning. The ability to allow the assets in the account to continue to grow tax-free can help clients continue to accumulate retirement savings that can be withdrawn tax-free if needed during retirement. This offers clients tax diversification in terms of their retirement savings. 

The estate planning aspect is critical with the new inherited IRA rules for most non-spousal beneficiaries under the Secure Act. Inherited Roth IRAs will pass tax-free to beneficiaries even with the 10-year rule as long as the original Roth IRA account holder had met the five-year rule requirements prior to their death. 

A Roth IRA will allow a broader range of investment options than a Roth 401(k), where the menu is limited by the options offered by the plan sponsor. This offers much greater flexibility for your client in terms of options like individual stocks, ETFs and mutual funds. 

Roth IRA Drawback: Contribution Limits

The biggest downsides of a Roth IRA account are the income limitations on the ability to contribute and the relatively low annual contribution limits. For 2021, the overall IRA contribution limit is $6,000, with an additional $1,000 in catch-up contributions available for those 50 and over at any point during the year. 

The 2021 income limits for Roth contributions are: 

  • For those who file as single, the income phaseout begins at a modified adjusted gross income (MAGI) level of $125,000 with no contributions allowed at a MAGI above $140,000.
  • For those filing married and joint, the income phaseout begins at a modified adjusted gross income (MAGI) level of $198,000 with no contributions allowed at a MAGI above $208,000. 

What Are the Benefits of a Roth 401(k)?

Roth 401(k) accounts, also known as designated Roth accounts, have become increasingly common. These accounts have many similarities to Roth IRAs, but also some differences. 

Contributions to a Roth 401(k) are made with after-tax dollars like a Roth IRA. Also like a Roth IRA, qualified distributions made after age 59 ½ are tax-free. 

One of the biggest advantages of a Roth 401(k) is that there are no income limits on your client’s ability to contribute to their Roth account in the plan. They are able to contribute up to the full amount of salary deferrals allowed for the current calendar year regardless of how high their income is. For 2021 these limits are $19,500 for those under 50 and $26,000 for those participants who are 50 or older at any point during the year. 

If the client’s employer offers a match on a portion of the employee’s contributions, this is another advantage of a Roth 401(k) account. Money from an employer match is akin to free money and can add to your client’s 401(k) balance and overall retirement savings amount. Any employer matching contributions are made to your client’s traditional 401(k) account by law. 

Your client may be able to take a loan from their Roth 401(k) account if their employer’s plan has a loan provision. This can offer an added degree of flexibility in being able to access their money in the plan if needed. 

Another advantage that might benefit some of your clients is that money in a 401(k) account, Roth or traditional, is generally protected from creditors. This can come into play if your client is in a profession that is prone to lawsuits. Creditor protection for assets in an IRA is much more limited. 

Roth 401(k) Drawback: RMDs

A key difference between a Roth 401(k) account and a Roth IRA surrounds RMDs. Unlike with a Roth IRA account, Roth 401(k) account holders must take RMDs from their account upon attaining age 72.   

Clients who are employed at the time RMDs are supposed to begin can defer RMDs from their 401(k) account with their current employer if they are not 5% or greater owners of the company and if their employer has made the proper election. 

What Is a Roth IRA vs. Roth 401(k)? A Quick Comparison

This chart highlights some of the key differences and similarities between a Roth IRA and a Roth 401(k). 

What is a Roth IRA vs. a Roth 401(k)?

Can You Have a Roth IRA and a Roth 401(k)?

If a Roth account makes sense for your client as part of their financial plan, both types of Roth accounts can be used together or separately at different points in time. 

For clients whose retirement savings are primarily in traditional IRA and 401(k) accounts, the use of either or both a Roth IRA or a Roth 401(k) can make sense as a means to help your client diversify their tax base in retirement. 

During years when their income is too high to contribute to a Roth IRA, a Roth 401(k) can provide an option for clients looking to add to their overall Roth account balance. 

A Roth IRA is a good rollover destination for money held in a Roth 401(k) account when your client leaves their company. This allows the money to continue to grow tax-free and allows the funds to be exempt from RMDs when clients reach age 72. 

As the Biden tax plan moves forward, strategies involving Roth accounts, such as Roth conversions, will become even more prevalent as advisors look for ways to help their clients reach their goals in the most tax-efficient manner.

History of Roth Savings Accounts 

Roth IRAs were established as part of the Taxpayer Relief Act of 1997. They got the name from the late Delaware senator William V. Roth Jr., who was the bill’s sponsor. The first Roth IRA accounts were opened in 1998. 

Roth 401(k) accounts came into being in 2006 when designated Roth accounts, as they are officially known, were permitted in 401(k) and 403(b) plans. In 2010, designated Roth accounts were permitted in governmental 457 plans as well. 

Today, both Roth IRAs and Roth 401(k) accounts are a popular option among investors and financial advisors. Younger retirement savers seem especially drawn to Roth accounts, and those whose income prohibits contributions to a Roth IRA continue to take advantage of Roth 401(k) accounts. 

Conclusion: Which Is Better, Roth 401(k) or Roth IRA? 

The answer to this question, like many others in the financial planning realm, is that it depends on your client’s situation. Both types of Roth accounts can be useful together or separately at different points in time.

A Roth account can be a useful planning tool for clients who may find themselves in a high tax bracket in retirement due to pension income or high levels of RMDs. Doing a conversion to a Roth IRA while tax rates are relatively low on a historic basis might make sense for some clients. 

The Roth 401(k), with its higher contribution limits, can be a key planning tool for clients a number of years away from retirement who want to boost assets in a Roth retirement account. 

Roth IRAs are useful accounts on their own, but also as part of planning strategies such as a Roth conversion, a backdoor Roth or a mega backdoor Roth. They are the logical destination for rollovers from Roth 401(k) accounts, and even conversions from a traditional 401(k) account to a Roth IRA. A critical benefit of a Roth IRA is the fact that no RMDs are required, making the Roth IRA a powerful retirement and estate planning tool. 

Roth and traditional IRAs and 401(k) accounts all can have a place in a client’s financial planning based on their situation and their goals. This will change over time in many cases, and your advice regarding the best retirement accounts for their needs over time is critical.

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