By April Caudill, JD, CLU©, ChFC©, AEP – Senior Attorney, Advanced Planning
The fact that Roth IRA and Roth 401(k) accounts share the same name doesn’t mean they are treated the same way. To avoid unwanted tax surprises, it’s important to be aware of how these two retirement tools differ.
A Roth 401(k) and a Roth IRA sound similar—and in many respects, they are. Contributions to both are made with after-tax dollars, and earnings can be withdrawn income tax-free under certain circumstances.1 But that’s where the similarities end.
Roth 401(k)s and Roth IRAs differ in a few significant ways. Because of this, it’s important to understand their key attributes so that you can direct your savings to the right plan today and avoid unwanted tax surprises down the road. To see why, consider the following hypothetical example.
Lisa, age 51, is a participant in a 401(k) plan of a large company. In 2008, when her former employer first offered a Roth feature in its 401(k) plan, Lisa began directing all of her 401(k) contributions to a Roth account.2
Why did she make the switch?
Lisa elected to contribute to a Roth 401(k) because she recognized that after-tax elective deferrals might end up being more valuable to her in the future than pre-tax deferrals from a regular 401(k) today. Here’s why.
In a traditional 401(k) account, the contributions you make are not included in your taxable income. You do not pay income tax on them until you receive a distribution. In a Roth 401(k) account, your contributions are included in your income the year you make them. Both types of accounts grow tax-free, but withdrawals from the Roth account during retirement are not subject to income tax, provided you’re at least 59½ and you’ve held the account for at least five years. If, like Lisa, you expect your tax rate to be the same or higher in retirement than it is today, then a Roth 401(k) might make sense.
In contrast, if your income puts you in a higher tax bracket now than you’re likely to be in during retirement, then contributing to a traditional 401(k) account might be a better choice. First, any pre-tax contributions you make to the plan will help to lower current taxable income today, when your tax rate is higher. Second, you’ll also be able to defer paying taxes on those contributions and any investment earnings until after retirement, when your tax rate may be lower.
Two years ago, Lisa changed companies. She now directs all of her 401(k) contributions (including catch-up contributions, which she is now eligible to make) into the Roth account of her current 401(k) plan.
In addition to her 401(k) plan savings, Lisa also has a Roth IRA that she opened when Roth IRAs first became available in 1998. At that time, Lisa met the income requirements for Roth IRAs and was able to contribute the maximum permitted. Recently, however, a raise at work put Lisa’s income above the threshold for Roth IRA eligibility, so she can no longer add contributions to that account.
All told, Lisa now has three Roth accounts:
- A Roth IRA,
- A former employer Roth 401(k), and
- A current employer Roth 401(k).
Lisa, a life-long renter, is getting ready to buy her first house and is wondering if she can take money from either her old Roth 401(k) account or her Roth IRA to help fund her down payment.
First, contributions to her Roth IRA can be withdrawn income tax- and penalty-free. In fact, withdrawals from a Roth IRA are considered as coming first from contributions, then from any conversion amounts, then lastly from growth.3 In contrast, withdrawals from a 401(k) account are treated as pro rata distributions of contributions and growth.
In order to have a “qualified distribution,” meaning that growth is distributed income tax- and penalty-free (in addition to the contributions and conversion amounts being tax-free), Lisa must meet two requirements:
- The account must be at least five years old. In the case of the Roth IRA, this is met if any Roth IRA that Lisa owns is at least five years old. In the case of the Roth 401(k) account, that particular Roth 401(k) account must be at least five years old.4
- For a Roth IRA, the distribution must also meet one of the following qualifying events.5
- Lisa must be at least 59½ years old.
- The withdrawal is made to a beneficiary or to her estate as a result of her death.
- The withdrawal is made because she is permanently disabled.
- The withdrawal of up to $10,000 (lifetime limit) is used for a first-time home purchase. (Someone may qualify for the “first-time” home purchase if he or she has not owned a home for at least two years prior to the date on the purchase contract or the date when construction started. The IRA owner, his or her spouse, or a relative or either of them may qualify as the buyer.)6
- For a Roth 401(k), the rule for qualified distributions is limited to payments made after age 59½ or on account of death or disability. First-time home purchases are not covered.
The bottom line for Lisa is that she can withdraw any contributions from her Roth IRA as well as up to $10,000 of growth, income tax-free and penalty-free.7
Lisa also would like to streamline her accounts. Specifically, she is considering whether to roll over her old Roth 401(k) account and, if so, whether she should have it transferred directly to her Roth IRA or her new Roth 401(k) account.
- Rollover Issues
Legally, the old Roth 401(k) funds can be rolled over to either the Roth IRA or the new Roth 401(k) account (assuming the new 401(k) plan accepts rollovers).8 However, there are certain pros and cons of having funds in an IRA versus a qualified plan that should be considered before making the direct transfer.9
- Among other things, Lisa should realize that in-service distributions are generally prohibited from a 401(k). This means Lisa would have the ability to take money from the Roth 401(k) with her former employer but not from the account with her current employer. As a result, if she wants access to the funds, Lisa generally shouldn’t roll over to the current Roth 401(k) unless the rolled-over portion will be accounted for separately.10
- If Lisa rolls over the old Roth 401(k) account into her Roth IRA, it will take on the “age” of the Roth IRA for purposes of complying with the five-year rule.11 However, if it goes to the new Roth 401(k), it will take its “age” with it, and the new plan will be treated as if her participation began in 2008.12
- Recharacterization -- Okay with Roth IRAs, but not Roth 401(k)s
What if Lisa decides to convert other (pre-tax) 401(k) funds into her Roth 401(k) account? She should be aware that the Roth 401(k) does not allow a “do-over” if her market timing happens to be poor. Although a Roth IRA conversion can be recharacterized by the extended due date for Lisa’s income tax return for the year of the conversion,13 the same is not true of a Roth 401(k).14
- Required Minimum Distributions
A final issue that Lisa will want to keep in mind is that during her lifetime, required minimum distributions must be made from her Roth 401(k) account,15 but not from her Roth IRA.16 This can easily be resolved at retirement by rolling the Roth 401(k) funds into her Roth IRA.
As you can see, there is no easy answer to the question, “Which is better, a Roth IRA or Roth 401(k)?” As with any major financial decision, you’ll want to consult your financial representative and your tax advisor to help ensure whatever choice you make is the one that’s most appropriate for your situation.
|Contribution dollar limit (2013)
||$5,500 plus $1,000 catch-up if 50 or over
||$17,500 plus $5,500 catch-up if 50 or over|
|Eligibility for full contribution (2013)
||Under $178,000 (married filing jointly) or under $112,000 (single or head of household)
||No income limits|
|5-year rule: use just oldest account, or count accounts separately?
||One for all Roth IRAs, but calculated separately for conversion amounts
||Separate for each Roth 401(k) account|
|5-year rule: effect of rollover from Roth 401(k)
||Rolled-over funds take on age of oldest Roth IRA
||Receiving account takes on age of older rolled-over funds|
|Events for qualified distribution (5 years and ...)
||Age 59½, disability, death, first-time homebuyer (up to $10,000)
||Age 59½, disability, death|
|Distributions: ordering v. pro-rata
||Ordering rules: first from contributions, then conversions, then growth
||Each distribution contains a pro rata allocation of contributions and growth|
|RMDs required during owner’s lifetime?
|Recharacterization back to non-Roth permitted?
||Yes, by extended due date of income tax return for year of conversion
1Distributions from contributions are never taxed as income, of course, because they are not deductible and so are post-tax money to begin with.
2A Roth account in a 401(k) plan is known as a “designated Roth account,” and the contributions to it are known as “designated Roth contributions.” IRC Sec. 402A(b)(2), (c). A designated Roth account can also be offered in a 403(b) Tax Sheltered Annuity as well as an eligible Section 457(b) plan. See IRC Sec. 402A(e)(1).
3See IRC Sec. 408A(d)(4)(B).
4See IRC Sec. 402A(d)(2)(B)(i), and Treas. Reg. Sec. 1.402A-1, A-4(a). But if Lisa were to make a conversion of pre-tax funds from her old 401(k) plan to her Roth IRA, that conversion amount would have its own five-year rule. See Treas. Reg. Sec. 1.408A-6, A-5(c). For both Roth IRAs and Roth 401(k)s, the five-year period starts on January 1 of the year the first contribution was made. Treas. Reg. Sec.1.408A-6, A-1(b) and A-2.
5See IRC Secs. 402A(d)(2), 408A(d)(2).
6See IRC Secs. 408A(d)(2)(A)(iv), 408A(d)95), 72(t)(2)(F).
7See IRC Sec. 72(t)(8).
8See IRC Sec. 402A(c)(3). These are the only accounts into which a rollover of Roth 401(k) amounts can be made.
9See “The Rollover Decision: Knowing When to Hold ’Em and When to Fold ’Em,” Advanced Planning Bulletin (June 2011).
10See Treas. Reg. Sec. 1.402A-1, A-9. The distribution restrictions that apply to 401(k) plans are explained at IRC Sec. 401(k)(2)(B).
11See Treas. Reg. Sec. 1.408A-10, A-4.
12See IRC Sec. 402A(d)(2)(B)(ii).
13See IRC Sec. 408A(d)(6).
14Notice 2010-84, 2010-51 I.R.B. 872, A-6.
15See Treas. Reg. Sec. 1.401(k)-1(e)(4).
16See Treas. Reg. Sec. 1.408A-6, A-14(a). Required minimum distributions normally begin after age 70½, but if Lisa is still working after age 70½, she can delay distributions until after retirement as long as she is not a more than 5% owner of the employer.