Roth 401k vs Roth IRA. What Works Best?

If you are socking money into your 401k at work you get an “A” in Retirement Planning 101. Congratulations. You are ready for Retirement Planning 201. That’s where the Roth 401k and Roth IRA come in.

Refresh Yourself

When you contribute to your traditional 401k you become “The Man”. That’s because everything starts working for you. The contribution you make reduces your taxable income and therefore saves you on taxes. Yessire.

And your total 401k grows without being subject to tax as long as you keep the money in your plan. That means it grows faster since there is more money working for you. Just like I said, you are “The Man” and your money is your minion. Powerful stuff.

What questions do you have on your retirement plan at work?  connect with me. and if I can help clarify I’ll be happy to do so.

Of course when you start dipping into the account you’ll pay tax on your withdrawals. But don’t be sad. Because of the immediate tax break you got when you made the contributions and because of the years of tax-deferred growth, you are far better off by taking advantage of the 401k. Again, this is all retirement planning 101. Let’s move on and assume you want to do a rollover to a Roth 401k or Roth IRA and need to make a decision.

Enter the Roth

If you use a Roth IRA or Roth 401k you won’t get a tax break when you contribute your money. But, and this “but” is big, the money grows tax free. And if you keep your account for at least 5 years and are at least age 59 ½, the money you take out will also be tax-free. SHWEEEEEEET.

Now let’s assume that you like this Roth idea but you need to decide between a 401k Roth or a personal Roth IRA. Which is better for you? You might have this choice even if you are still on the job. Many employers allow employees to have either by making an “in service conversion”. That just means they might allow you to move the money out of the 401k and into a Roth 401k or IRA Roth. Even if your boss doesn’t provide this option, there are other ways to skin a Roth cat. Hang in there.

First, let’s look at the Roth IRA and compare it to the 401k Roth.

With a Roth IRA, you can withdraw money of course (subject to the conditions I shared above) but you never have to take any money out during your life time. So if your end-game is to leave a big wad of dough to your heirs, this is a pretty cool way to do it. The money grows tax-free. Even once your heirs tap into it, they only have to withdraw a small amount. Those withdrawals are tax free and the balance continues to grow tax free for the inheritors as well. Can’t get much better than that Dawg.

Keep in mind that if you aren’t past the 59 ½ – 5 year hurdle, your withdrawals are treated differently by the Roth IRA vs. Roth 401k. The Roth IRA considers any early withdrawals to be after-tax contributions first so if you only take a minimum amount, it could be tax free. But with the Roth 401k, some of your early withdrawal will be considered taxable depending on your balances. That means you’ll likely pay a penalty and tax on early withdrawals. Again this is only an issue if you don’t pass the hurdle mentioned above.

Another key difference is the “do over” available with the Roth IRA. Let’s say you convert the account this year when the value is $250,000. Then the market slumps and now your Roth IRA is slashed to $200,000. You can re-do your conversion as if you did it under the current market value. If you do the re-do, your conversion value is $200,000 rather than $250,000, and the tax on the conversion is far lower. And you can take advantage of the “do over” until October 15th in the year following the conversion. Nice of the IRS boys.

Sadly, the 401k Roth conversation doesn’t have any “do over” option. Less flexibility. Bad tone.
The other big advantage to the Roth IRA is that you have basically unlimited investment options compared to a skinny little list of Roth 401k investment choices usually made available by the employer.

Does The 401k Roth Ever Beat The Roth IRA?

Sure does. About half the 401k plans out there allow you to convert your 401k to a Roth 401k no matter how old you are. And you probably can do this even if you are still on the payroll as long as they offer in-plan conversions.

But you’ll have to wait until you leave your employer or reach age 59 ½ if you want to convert to a Roth IRA. And since employer-sponsored plans are more lawsuit-proof and bankruptcy-proof than IRAs the Roth 401k gives you more protection.

A Roth 401k might provide loan provision in case you get into a tight spot. I’m never a fan of borrowing from retirement plans but it’s a nice feature to have in case of emergency.

Last, your boss lady might sweeten the 401k Roth plan with matching contributions. You won’t be seeing any of that with the Roth IRA.

The Roth concept doesn’t work for everyone. I haven’t converted my IRA because it just doesn’t fit my investment plan. But for many people it works great. Does the Roth work for you? Are you going to convert or use a 401k Roth or Roth IRA? Why or why not?