Many employers now offer Roth versions of their 401(k) plans. Though many people believe Roth IRAs and Roth 401(k)s (known formally as designated Roth 401(k) plans) are identical, there have been important differences between the two types of retirement plans. But a major difference was eliminated in late 2022 when the law known as SECURE Act 2.0 was enacted.
You know the basic differences between Roth-type accounts and traditional IRAs and 401(k)s. In the traditional accounts, most contributions are either deductible (IRAs) or not included in gross income (401(k)s). Contributions to Roth accounts are included in gross income; you’re contributing after-tax money. Distributions from the traditional accounts are taxed as ordinary income, unless they are distributions of after-tax money. Distributions of income from Roth accounts are tax-free after the five-year waiting period.
But Roth IRAs and Roth 401(k)s aren’t exactly the same. You should know the differences. The knowledge will help you decide whether to open a Roth 401(k) or Roth IRA. It also might influence a decision of whether to keep money in a Roth 401(k) or roll it over to a Roth IRA.
The contribution maximums of the two accounts are different.
The maximum IRA contribution is $6,500 in 2023 with an additional $1,000 catch-up contribution for those age 50 or older. But the maximum deferral to a 401(k), whether Roth or traditional, is $22,500 in 2023 with an additional $7,500 catch-up contribution allowed for those 50 and older.
There’s an income limit for contributions to Roth IRAs. The maximum contribution begins to be reduced for a single taxpayer when adjusted gross income exceeds $138,000 and is reduced to $0 when adjusted gross income exceeds $153,000. For married couples, the phaseout begins at $218,000 and ends at $228,000 of adjusted gross income. There are no income limits for 401(k) contributions.
The SECURE Act 2.0 made an important change to catch-up contributions to employer plans, such as 401(k)s. The catch-up contributions will be treated as Roth contributions after 2023 when made by an employee whose wages from that employer the previous year exceeded $145,000. The amount is indexed for inflation. The treatment applies whether the employee is making contributions to a traditional 401(k) or a Roth 401(k) account.
This means those catch-up contributions will be included in the employee’s gross income for the year.
That change applies only to employer plans, not to IRAs. In addition, it applies only if the plan allows all participants to choose whether catch-up contributions and other elective deferrals will be treated as either traditional contributions or Roth contributions.
Employers can make matching contributions to Roth 401(k)s just as they can with traditional 401(k)s. The maximum of combined employer and employee contributions is the same for both traditional 401(k) and Roth 401(k) accounts, $66,000 or 100% of the employee’s compensation (whichever is lower) in 2023 or $73,500 for those 50 and older.
Before the SECURE Act 2.0, employer-matching contributions to a Roth 401(k) always were of pre-tax dollars. They weren’t included in the employee’s gross income and were placed in a traditional 401(k) account. Distributions from that account were taxed as ordinary income.
The SECURE Act 2.0 allows employer plans to provide an election in which plan participants can choose whether to have matching contributions treated as Roth or traditional plan contributions. The employer doesn’t have to offer this option but is allowed to. The 401(k) has to be amended to allow the option.
Most Roth IRAs can be invested in any publicly-traded investment. But Roth 401(k)s can be invested only in the investment options available through the plan. A Roth 401(k) might have a brokerage window option that allows the account to be invested in almost any publicly-traded investment.
Before the SECURE Act 2.0, there was a major difference in lifetime required minimum distributions (RMDs) between Roth IRAs and Roth 401(k)s. Original owners of Roth 401(k), and Roth 403(b), accounts had to take RMDs during their lifetimes under the same rules as for traditional accounts. This was a major difference between Roth IRAs and employer-sponsored Roth accounts.
After 2023, the RMD requirement for original owners is eliminated for employer-sponsored Roth accounts. They’ll be on par with Roth IRAs. Beneficiaries who inherit Roth IRAs or employer-sponsored Roth accounts still will have to take RMDs.
You can take tax-free loans from a Roth 401(k) under certain circumstances, but you can’t take a loan from a Roth IRA. You can only take distributions from a Roth IRA, and there will be a 10% penalty if it is taken before age 59½ unless you qualify for one of the exceptions.