Roth IRA vs. Roth 401(k): Which Is Better?

Many of you are familiar with the tax advantages that Roth retirement accounts can bring. Although Roth contributions are made with after-tax dollars, the contributions grow tax-free, and earnings also come out tax-free after age 59½ if a five-year holding period has been satisfied.

A recent survey by the Plan Sponsor Council of America showed that 93% of 401(k) plans offer employees the option of making Roth 401(k) salary deferrals. Let’s say your plan allows Roth contributions, but you don’t have the funds to maximize both those contributions and Roth IRA contributions. Which one should you contribute to? It turns out that each option has its own advantages.

Here are the reasons why Roth IRAs are more attractive than Roth 401(k)s:

• Roth IRAs offer unlimited investment choices, but Roth 401(k)s are limited to whatever investment options the plan offers.
• You usually can’t withdraw your Roth 401(k) account until you turn age 59½ (or leave your job). By contrast, Roth IRAs are always available (although earnings may be taxable and subject to penalty).
• The rules for determining whether a Roth distribution is a “qualified distribution” (that is, whether earnings come out tax-free) is easier to satisfy for Roth IRAs than it is for Roth 401(k)s. For Roth IRAs, the five-year holding period begins with the first contribution or conversion to any Roth IRA. For Roth 401(k)s, the five-year period begins with the first contributions to that particular 401(k) plan.
• Roth IRA distributions that don’t meet the conditions for a “qualified distribution” are subject to favorable ordering rules allowing you to withdraw all of your tax-free contributions and conversions before your taxable earnings. On the other hand, Roth 401(k) distributions that are not qualified must meet a pro-rata rule that causes a part of the distribution to be taxable.
• Before 2024, Roth IRAs had an advantage over Roth 401(k)s when it came to lifetime required minimum distributions (RMDs). Roth IRA owners have never been required to take RMDs, but up until 2024, Roth 401(k) owners were required to take them. Now, neither is subject to lifetime RMDs.

On the other side of the coin, Roth 401(k)s may be a better option for the following reasons:

• Roth 401(k) funds may offer you more protection from creditors than Roth IRAs if you wind up on the losing end of a lawsuit. If the Roth 401(k) is part of an ERISA plan, you have an unlimited shield from creditors’ claims. By contrast, Roth IRAs only give you the creditor protection available in the state where you live. State law can provide less protection than ERISA does.
• Most plans allow employees to borrow against their Roth contributions, but Roth IRA owners are not allowed to take loans against those funds.
• Many 401(k) plans will match Roth 401(k) employee contributions, but your custodian won’t match your Roth IRA.
• Unlike Roth IRA contributions, Roth 401(k) contributions are not subject to annual income limits (although the plan may restrict contributions made by highly-paid employees).

If you have technical questions you would like to have answered, be sure to submit them to mailbag@irahelp.com, to be answered on an upcoming Slott Report Mailbag, published every Thursday.

Roth IRA vs. Roth 401(k): Which Is Better?