Roth 401(k)s and Roth IRAs have a lot in common. Both offer the ability to make after-tax contributions now in exchange for tax-free earnings down the road if the rules are followed. However, there are some important differences between the two plans that you will want to understand.
One major difference is the amount that you may contribute. Your Roth IRA contribution is limited to a maximum of $5,500 for 2017 if you are under age 50. If you are age 50 or older this year, you may contribute up to $6,500. A Roth 401(k) offers much higher limits. You can defer $18,000 for 2017, or $24,000 if you are 50 or over.
Roth 401(k)s do not have any income limits on contributions. If you are a high earner you will still be able to make deferrals. That is not the case for Roth IRAs. In 2017, your ability to contribute to a Roth IRA will begin to phase out when your income exceeds $118,000 ($186,000 if you are married, filing jointly). If your income is too high and you would like to fund a Roth IRA, you may want to explore the back-door Roth IRA strategy as a way around these limits.
Roth IRAs offer the advantage of no required minimum distributions (RMDs) during your lifetime. This is not the case for Roth 401(k)s. You will need to take RMDs from your Roth 401(k) when your reach age 70 1/2. An exception may apply if you are still working for the company.
Roth 401(k) funds can be rolled over to a Roth IRA. However, the opposite is not true. You may not roll over your Roth IRA to your Roth 401(k)
When it comes to funding either a Roth 401(k) or a Roth IRA, the goal is to take tax-free distributions someday. For this to happen, you must have a qualified distribution. The rules for qualified distributions from Roth IRAs are more favorable than those for Roth 401(k)s. You can take a qualified distribution for a first home purchase, which is not allowed with a Roth 401(k). Also, your five-year period starts with your first contribution to any Roth IRA. For Roth 401(k)s, the five-year period for qualified distributions applies separately to each plan.
What if you take a distribution that is not qualified? The rules for nonqualified distributions are also more favorable from Roth IRAs than Roth 401(k)s. With a Roth IRA, the ordering rules say that earnings will leave the Roth IRA last. This means that the only funds that would be taxed will come out after all your other Roth IRA funds have been distributed. With Roth 401(k)s you are not so lucky. A distribution that is not a qualified distribution is subject to the pro-rata rule. A portion of each distribution will be taxed.
Which is Best for You?
You now understand there are some advantages to a Roth 401(k) especially when it comes to contributions. However, a Roth IRA may be preferable when it comes to taking distributions and avoiding RMDs. Which is best for you? Not everyone has a choice. Your employer may not offer a Roth 401(k). These plans are becoming more popular but are not always available. If you do have a choice, you will want to weigh the pros and cons to both Roth 401(k)s and Roth IRAs. There is not one answer that is right for everyone. If you have questions about your own situation, you should consider meeting with a knowledgeable financial advisor.