If you’re debating between investing in a Roth IRA vs Roth 401k, the first thing to know is that you don’t have to choose. You can invest in both. Before you decide, you should know the differences and benefits of both types of accounts.
The term “Roth” is for Senator Roth, the chief sponsor of the Taxpayer Relief Act of 1997. That is when the Roth IRA came into existence. The Roth 401k came about in 2001. Unlike traditional retirement accounts, the Roth versions are funded with after-tax dollars and allow the owner to make tax-free withdrawals during retirement. Tax-free provides a unique option when it comes to planning for retirement. Not only are the original contributions withdrawn tax-free, but all of the investment earnings are also tax-free at retirement. This is unique because other retirement income sources are still taxable in retirement – including Social Security, traditional IRAs, and traditional 401ks.
Now, for the differences between a Roth IRA vs Roth 401k. A Roth IRA can allow your investments to grow for a longer period. The Roth IRA does not require you to take Required Minimum Distributions (RMDs) – ever. The Roth 401k does have RMDs once you reach age 72. However, the Roth 401k does not have an income limit, meaning that people with high incomes can still contribute.
Importantly, the Roth 401k has much higher contribution limits. Both accounts make early withdrawals easier because the taxes have already been paid on the contributions – taxes and penalties are due on early withdrawals of the untaxed earnings. Taxes on early withdrawn earnings of a Roth IRA make the Roth 401k preferred. That’s because loans are allowed with the Roth 401k that are not taxed or penalized. A Roth IRA does not allow loans. Also very noteworthy is that Roth Solo 401k accounts offer many more investment options in alternative assets. Roth accounts sponsored by major employers do not allow alternative investments.
Roth IRA vs Roth 401k: Contribution Limits
Roth IRA Contribution Limits. Your eligibility to contribute to a Roth IRA is based on your income level. Your Modified Adjusted Gross Income (MAGI) plays a significant role in your eligibility and how much can be contributed. For single tax filers to make the maximum contribution in 2022, their MAGI must be under $129,000. The amount they are allowed to contribute phases out – up to a MAGI of $144,000.
For married couples filing jointly, their MAGI must be under $204,000. The amount they are allowed to contribute phases out – up to a MAGI of $214,000.
The maximum total annual contribution for all your IRAs combined is:
- $6,000 if you’re under age 50
- $7,000 if you’re age 50 or older
Roth 401k Contribution Limits. Along with much higher contribution limits, frequent increases in the contribution limits are another reason the Roth 401k is superior when it comes to Roth IRA vs Roth 401k. In 2021 the IRS announced changes to 401k plans for 2022, allowing employees under the age of 50 to contribute up to $20,500 per year to their Solo 401k, an increase of $1,000 from 2021. The catch-up contribution for employees age 50 and older is $6,500, for a total contribution limit of $27,000. The combined total employer and employee contributions cannot exceed $61,000 for the year or $67,500 for employees age 50 and older. A married couple can double those limits to $122,000 if both are under age 50 or $135,000 if both are age 50 or older.
A Roth Solo 401k subaccount comes with your Solo 401k. Having both allows for the highest contribution limits and the most flexible tax-saving strategy for high income earners.
You don’t have to choose Roth IRA vs Roth 401k when it comes to contributions. You can have both accounts at the same time. This can be a highly effective savings strategy. However, a strategy with a traditional 401k and a Roth IRA (or the other way around) can be the most effective. The traditional 401k and a Roth IRA combination can create long and short-term tax advantages by having both tax-deferred and tax-free retirement accounts. However, you must follow the eligibility and contribution rules for both, and these are a little different when you have multiple retirement accounts.
Contributing to Traditional and Roth Accounts – Is it Worth It?
Traditional 401k contributions effectively reduce both adjusted gross income (AGI) and modified adjusted gross income (MAGI). One strategy could be making tax-deferred contributions to a traditional Solo 401k to bring your MAGI down to an amount that allows more or full contributions to a Roth IRA. This could both maximize your retirement savings and reduce annual taxes. Additionally, contributing to these accounts may make you eligible for a tax credit known as the Saver’s Credit, which could be up to 50% of your contributions.
The 401k account has no income limit, but there is a limit on how much you can contribute annually. If you have a unique situation with more than one employer and/or a Solo 401k, you must ensure that you don’t go over the employee contribution limits for the year if you are contributing to multiple 401k accounts within the same year.
What About Employer 401k and Roth IRAs?
If your employer matches 401k contributions, it’s typically wise to take full advantage of those before contributing to a Roth IRA. For a Roth IRA account, you should make sure that you will not exceed the income thresholds the IRS sets. Also, there are advantages to having both an employer-sponsored 401k and Solo 401k. With two (or more) 401k accounts, a single contribution limit only applies to the employee salary deferral contributions. You can still contribute the maximum employer amount from both the employer-sponsored 401k and Solo 401k. Multiple 401k accounts can be either Roth, traditional tax-deferred, or both.
There can be even more advantages to having both a Solo 401k and Roth IRA account. The Solo 401k also avoids the Unrelated Debt Financed Income (UDFI) tax that does apply to a Roth IRA. UDFI is a tax that applies when you borrow money to help finance your investments. The Solo 401k is not subject to UDFI, but the Roth IRA is subject to this high tax that can be as much as 37% in 2022.
Use a Roth Solo 401k To Capture Even More Tax-Deferred Gains
A good strategy when you have multiple 401k accounts can be rolling over 401k accounts from previous employers into a Solo 401k to make these easier to manage. This is because you gain full control of your investments, and can pool your money into the same account for large investments like real estate and private placements. Another benefit is eliminating administrative and other fees on multiple accounts while receiving exceptional services with your Solo 401k. Also, consider your time savings by no longer managing multiple accounts.
Setting up your Solo 401k is the first step in this multi-prong strategy to maximize retirement savings and minimize taxes. Your Solo 401k can include additional unlimited sub-accounts for your spouse as well – tax-deferred and Roth. Every Solo 401k includes a Roth 401k subaccount for you and one for your spouse, even if you make too much money to be allowed to contribute to a Roth IRA. All great perks in the question of Roth IRA vs Roth 401k?
There are no drawbacks to using a Roth IRA vs Roth 401k. However, the Solo 401k does require that you be self-employed and not have any employees. There is also the RMD difference between a traditional IRA and a Roth IRA. The Roth IRA does not require withdrawals until after the death of the owner. The traditional IRA and Solo 401k do require a first minimum distribution by April 1 of the year after you reach 72.
On the other hand, the Solo 401k does offer many superior benefits over the IRA. A Solo 401k automatically comes with a Roth Solo 401k subaccount. The Roth Solo 401k account has all the advantages of a Roth IRA with the exception that RMD is required with a Roth Solo 401k but not a Roth IRA. Importantly, the Roth Solo 401k does not have the income limit that the Roth IRA has. Other important advantages of Roth IRA vs Roth 401k are the high contribution limits for Roth 401ks, avoiding Unrelated Business Income Tax (UBIT) on leveraged real estate, and the ability to take loans that are tax and penalty-free.
As a business owner, you can have a Solo 401k (providing you meet all the requirements) and you can make an employee deferral just like you can with a company you work for as well as the employer contribution component. If you have a spouse that is working in your business and is employed by your business, they can also take advantage of the Solo 401k as a participant of the plan.
The Solo 401k drawback can be that to qualify for a Solo 401k, your business must have zero employees (employees defined as those who work for you more than 1000 hours per year and receive W2 wages). However, you can have contract workers.
Generally, there are at least four good reasons why you might want to use a Roth Solo 401k account instead of a traditional Solo 401k account. (Keeping in mind that you can contribute to both during the same tax year as long as contribution limits are not exceeded).
Consider the power of compounding interest. A maximum $61,000 contribution to a Solo 401k this year that compounds at a modest 8% for 35 years becomes $976,000 without adding any more to the account (compounded quarterly). When you add $30,000 each year to that initial deposit of $61,000, the 35-year compounded total skyrockets to an amazing $6.4 million. All those earnings are tax-free with a Roth Solo 401k!
$50,000 participant loan is not in your best interest. A Roth Solo 401k allows the penalty-free withdrawal of contributed funds at any time after five years. This is very different than traditional IRA or 401k funds that are taxed as part of your current income and have a 10% additional penalty if withdrawn before age 59½. The reason is that you have already paid the taxes on the Roth funds. However, early withdrawals are prorated between (nontaxable) contributions and (taxable) earnings.
The simple truth is that many taxpayers will be financially better off paying all or some taxes today instead of during retirement. These are the people that should seriously consider a Roth strategy or a strategy that combines both a Roth Solo 401k and a traditional Solo 401k.
Wait – Don’t Roll Your Previous Roth 401k Into A Roth IRA Just Yet! You have more options than you probably realize. Make sure that you do what is in your best interest. For instance, do NOT roll a Roth 401k or Roth IRA into a traditional IRA or even a Solo 401k. The combination of tax-free and tax-deferred funds will become an accounting nightmare.
On the other hand, you can convert a traditional IRA or 401k into a Roth Solo 401k. You might want this option because you didn’t know about it previously, it is relatively new, or you are getting a late start with a Roth account but understand how you can still benefit financially.
If you want to convert a traditional tax-deferred account into an after-tax Roth account, the place to begin is by calculating the taxes that will be owed. Set aside enough money from outside your retirement account to cover what you’ll owe when you file your taxes. Tell us when you’re ready to make the conversion. We will provide the necessary forms. You have until the date you file your taxes to pay the tax bill. For example, if you convert in July, you’ll have until next April before the taxes are due.
Having a Roth Solo 401k in your financial future comes with:
- Qualified distributions are tax-free (completely different from the way a tax-deferred 401k pays taxes at distribution).
- Both your contributions and earnings grow tax-free and are distributed tax-free.
- Enables you to pay taxes at a lower bracket rate today if you anticipate a higher tax bracket during retirement.
- Protects against the possibility that Federal, State, and Local income tax rates will rise overall.
- Increases “tax diversification” (gives you access to assets taxed at different rates that provides both taxable income and tax rate flexibility).
- Can be a vehicle for providing a tax-free inheritance to loved ones.