You may have heard of these accounts and their tax benefits, but they're not exactly the same. They get confused with each other ALL the time, so I'll highlight some key features and how to take advantage, especially if you are a high-income earner and want to maximize your retirement savings.
First, let's look at the main differences:
Roth IRA vs. Roth 401k
Both allow you to invest and build up money that can potentially be withdrawn tax-free at age 59 and a half, but a Roth 401(k) can ONLY be opened through an employer that offers this option. You can't go and open one on your own (unless you are self-employed). A Roth 401k also allows you to make much higher contributions than you can to a Roth IRA.
A Roth IRA you CAN open on your own, but it's subject to income limits. This means that if your income is above a certain threshold, the IRS will not allow you to make a direct contribution to a Roth IRA. This is important to know because taxes and penalties can be assessed if you make an ineligible contribution.
How much can I contribute to a Roth IRA?
You can contribute up to $6,000 annually (or $7,000 if you're over 50 years old) to a Roth IRA in 2022. However, these contributions are subject to the income limits shown below:
For Single Filers, your Modified Adjusted Gross Income (MAGI) has to be under $129,000 to make a full contribution. Partial contributions are allowed until your MAGI reaches $144,000, at which point you cannot directly contribute to Roth IRA any longer.1
For Married Filing Jointly, your MAGI has to be under $204,000 to make a full contribution. Partial contributions are allowed until your MAGI reaches $214,000.1
As you can see, Roth IRA contribution rules discriminate against those making higher incomes.
So what can higher income earners do to maximize tax-free savings? Enter the Roth 401k!
How much can I contribute to a Roth 401k?
You can contribute up to $20,500 annually to a Roth 401k if you're under age 50. If you're 50 or older, that number rises to $27,000.
This is more than three times the Roth IRA contribution limit!
The great thing about Roth 401k is there are NO income restrictions. You can earn as much as you want and still make a FULL contribution to a Roth 401k.
- Mr. and Mrs. McGregor are under 50 and make a combined annual income of $380,000, putting them over the income limits to contribute to the Roth IRA.
- Their employers both offer a Roth 401k option though, so they are allowed to contribute $20,500 EACH into their Roth 401k's if desired.
- That's a max potential contribution of $41,000 to Roth 401k in a given year, compared to the Roth IRA max of $12K per year ($6K per person).
This is a BIG advantage to those earning higher incomes over the Roth IRA limits and who want to maximize their tax-free retirement savings.
Side note - If you receive an employer match, the matched portion will go into the pre-tax (or Traditional) 401k side and NOT the Roth 401k. The IRS will not allow your employer to add tax-free contributions to your account, so any match offered will always go into the pre-tax side.
Roth IRA or Roth 401k? Which one is right for me?
This will depend on how much you want to save a year, your annual income, and your tax strategy.
If your goal is to maximize tax-free savings and your employer offers a Roth 401k option, then it's a HUGE advantage, especially if you're receiving an employer match (that's essentially free money that you don't want to turn away).
You don't have to worry about income limits and can save more than three times the amount per year than you can in the Roth IRA. The good news is that most 401k plans now have the Roth option, although you may have to dig around on your 401k website portal to find it.
For high-income earners, the Roth 401k is even more of a bonus. If you're earning over the $214,000 threshold, it's the ONLY tax-free savings avenue the IRS is going to give you. It would be very wise to take advantage of it! The only other option you have is doing "backdoor" Roth IRA contributions, but that's still only $6,000 per person annually ($7,000 if you're over 50).
If you don't have access to a Roth 401k, don't plan on saving more than $6,000 per year, or want the flexibility to remove your contributions for an emergency, then using a Roth IRA might be a better choice.
Can I use BOTH Roth 401k and Roth IRA?
You can max out your Roth 401k AND a Roth IRA as well. Assuming you want to turbocharge your retirement savings and are under the income limits for Roth IRA, then you could contribute the maximum amount to Roth 401k and the maximum to Roth IRA in the same year.
- Jimmy and Kim are both 52, earn $190,000 per year (Married Filing Jointly), and want to maximize their tax-free retirement savings.
- Jimmy has a Roth 401k at work and contributed the max of $27,000 (since he is over 50) in 2022.
- He can also make a full contribution of $7,000 to his Roth IRA for the year since they are under the income limits ($204,000-$214,000). Kim can also make a $7,000 Roth IRA contribution for the year if she wishes.
- That's a total of $41,000 in Roth accounts for the year!
While it may not be practical for everyone to save that much in a given year, the above scenario demonstrates the potential available for those who wish to take full advantage.
If your goal is maximizing tax-free savings for retirement, then Roth 401k is the most advantageous by far, especially for high-income earners.
Nothing else really comes close. The contribution allowance of $20,500 ($27,000 if over 50) in 2022 is over three times higher than for Roth IRA. No income limits apply to Roth 401k contributions, and most 401k's receive an employer match. Hard to pass up!
If you don't have access to a Roth 401k, then Roth IRA would be your next best choice, provided you are under the income limits to contribute.
Roth 401k and Roth IRA can both be used at the same time. You can make a maximum contribution to a Roth 401k and also make a maximum contribution to a Roth IRA in the same year (assuming you are under the Roth IRA income limits).
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