We’ve said it before, and we’ll say it again: Saving for retirement is one of the most important financial goals you can tackle. One of the best ways to maximize your nest egg is by taking advantage of tax-free interest — and Roth investment accounts allow you to do just that.
Although Roth contributions won’t get you a tax break today, you do get to withdraw the money without paying taxes later. That means you’ll fully benefit from all the growth (compound interest) and keep every cent your money earns while invested.
Depending on your personal financial circumstances, however, you may be better served by either a Roth IRA or a Roth 401(k) — or by skipping the Roth option altogether and investing in a traditional retirement plan instead.
Roth or traditional: which is right for you?
Before we dive into the definition of each of these Roth accounts, let’s back up a step. How do you tell if a Roth or a traditional retirement account is best suited for your personal financial goals?
The difference between a Roth investment account and a traditional account all comes down to timing. You’re going to pay taxes on your contributions either way, but the question is, when?
In a traditional account, your contributions are tax-deductible and don’t count toward your annual income tax in the year they’re made. That means you get a nice tax break today but will pay taxes on your withdrawals as you make them later. And since the invested funds grow, that means you’ll also pay taxes on your earnings.
In a Roth account, on the other hand, your contributions are taxed now, but you get to withdraw the money tax-free later. That means you’ll get to keep the full amount of the earned through the market growth your investments see over time, which can make for a hefty retirement bonus.
A Roth account can be especially beneficial if you expect to be in a higher tax bracket at the time of your retirement than you are currently. For example, if you’re just starting your career and earning an entry-level salary, it makes more sense to pay the lower tax percentage today so you can skip paying a higher percentage later. Alternatively, higher earners may end up migrating to a lower tax bracket once they’re on a fixed retirement income, which means choosing a traditional, pretax retirement account could make more financial sense. Here’s more information on how to tell which type of retirement account will work best under your individual circumstances.
Roth IRA vs. Roth 401(k): how they compare
|Roth IRA vs. Roth 401(k) for 2019|
Income limit of $137,000 (single) or $203,000 (married)
No income limit
$6,000 limit (or $7,000 including $1,000 catch-up contribution for savers aged 50 or over)
$19,000 in personal income; $56,000 including nonelective or employer contributions ($25,000 and $62,000 including $6,000 catch-up contribution for savers aged 50 and over)
Required Minimum Distributions
No requirement to take distributions during the account holder’s lifetime
Distributions must start no later than age 70 and a half unless the account holder is still working and not a 5% (or more) owner of the sponsor company
Withdrawal Requirements and Terms
Withdrawals of contributions and earnings are not taxed as long as the account has been held for five-plus years and the qualified distributions are made:
May also withdraw a qualified distribution for a first-time home purchase
Same withdrawal requirements and terms as a Roth IRA but no specific exception for first-time home purchases (although some plans may allow you to take out a loan against your 401(k) for this and other purposes)
Employer Match Availability
Where to Open Account
Any brokerage firm
Through your employer
What is a Roth IRA?
A Roth IRA is a personal retirement account whose contributions are taxed today but withdrawn tax-free later. For 2019, you can contribute up to $6,000 per year to this type of account, or $7,000 including the $1,000 catch-up contribution for those aged 50 and over.
Roth IRAs carry some specific benefits that Roth 401(k)s do not. For instance, Roth IRAs are not subject to required minimum distributions, or RMDs, which means you can let your money grow indefinitely for as long as you live. Additionally, since you’ve already paid taxes on the money, you can make withdrawals from your Roth IRA contributions at any time without incurring additional taxes or penalties. (The growth you earn, however, would be subject to income tax and a 10% early withdrawal fee if you’re under the age of 59 and a half.)
Roth IRAs have a much lower maximum contribution limit than Roth 401(k)s, and income limits may keep you from participating if you make more than $137,000 per year (or $203,000 per year if you’re married filing jointly). As self-directed retirement accounts, IRAs also are ineligible for the employer match feature that can help make 401(k) plans so profitable.
When a Roth IRA makes sense
A Roth IRA is a good choice if your company doesn’t offer a 401(k) or if the company-sponsored plan leaves something to be desired. Contributions can be withdrawn at any time, causing some people to use a Roth 401(k) as a kind of emergency fund — although this is not an advisable strategy, according to Malik S. Lee, a certified financial planner with Felton & Peel Wealth Management in Atlanta.
Taking money out of your account means you’ll lose out on the benefits of compound interest, and since growth is still taxable, your financial paperwork can become a total mess if you don’t maintain proper records of your contributions.
What is a Roth 401(k)?
A Roth 401(k) is a company-sponsored retirement plan that allows you to make tax-free withdrawals on post-tax contributions. It’s a good idea to take advantage of company-sponsored Roth 401(k)s, especially if your employer matches your contributions. Even a 1% match means you’re earning free money toward your retirement at no additional cost to you.
Roth 401(k)s provide the opportunity to maximize your retirement fund with employer match programs and other nonelective deferrals. You can participate in your company’s Roth 401(k) no matter how much money you earn per year — which isn’t an option with Roth IRAs, as they do have an income threshold.
When a Roth 401(k) makes sense
There are some instances where it may make sense to skip your employer’s plan altogether. For instance, if the 401(k) carries a high management fee, it may end up costing you thousands of dollars in the long run. It’s also important to note that all employer match funds on Roth 401(k) contributions will be put into a traditional 401(k) to grow pretax.
Another consideration to keep in mind with a Roth 401(k) is that it may be subject to company- or custodian-specific limitations. For example, your Roth 401(k) may have restrictions on how often you can adjust allocations and contributions, which doesn’t apply to a self-directed account like an IRA.
The bottom line
Both Roth IRAs and Roth 401(k)s can help you take full advantage of compound interest to ensure you have an ample nest egg for retirement.
Depending on your specific financial circumstances and earnings, one account may make more sense than the other. If you’re looking to save aggressively, you might benefit from an investment account with a higher contribution limit, such as a 401(k). If your company doesn’t offer a 401(k), however, a Roth IRA might be your best option.