By Kaye A. Thomas
Current as of May 18, 2018
Designated Roth accounts offer some significant advantages over the Roth IRA.
Perhaps you’re already familiar with the Roth IRA and want to know how Roth accounts in employer plans, known as designated Roth accounts, stack up. Here’s a rundown of the major differences.
No income limitation
The Roth IRA isn’t available to taxpayers with income above certain levels. For unmarried filers, the contribution limit begins to phase out at $120,000 and is completely eliminated at $135,000, and for joint filers the contribution limit is eliminated as joint income moves from $189,000 to $199,000 (figures are for 2018). These limits shut the door on the world of tax-free retirement savings for many taxpayers.
Designated Roth accounts open that door, because these limits don’t apply to those accounts. If you’re eligible to participate in your employer’s 401k or 403b program, and the employer offers Roth accounts, you can make this choice without regard to your income level.
The dollar limits for 401k contributions are much higher than the limits for IRAs. Assuming you’re otherwise eligible, in 2018 you can contribute up to $5,500 to an IRA (including a Roth IRA), or $6,500 if you’re at least 50 years of age. For 2018 the general limit on contributions to a 401k or 403b account, including a designated Roth account, is $18,500, or $24,500 if you’re at least 50 years of age.
Various other limitations may prevent you from contributing the maximum amount to a 401k or 403b account, but most people who are eligible for these accounts will be able to set aside more money for retirement than they would if they relied solely on an IRA.
If your employer provides matching money for 401k or 403b contributions, you’ll get that match regardless of whether you put your money in a traditional account or a Roth account. The matching money goes into your traditional account even if you put your own contributions into a Roth account — but even in the traditional account, this matching money is adding to the wealth you’ll have in retirement.
You can set up a Roth IRA just about anywhere you want, and that means pretty much the entire world of investments is available to you. In a designated Roth account, just as in a traditional 401k or 403b account, you have to choose from among the investments your employer offers. Nearly all companies make sure the choices include some high quality mutual funds that are suitable for retirement savings, and it may actually work to your advantage to be able to focus on a narrower range of choices. Also, your employer may be able to offer some items, such as a stable value fund, you wouldn’t be able to put in your IRA.
One thing to watch out for. Some people load up their 401k account with stock of the company where they work. It’s okay to own some of your company’s stock, but putting more than 10% of your retirement savings into a single stock, no matter how good that stock might be, is hazardous to your wealth.
Access to your money
You should plan to keep hands off your retirement money until you’re retired, but emergencies do happen. If your money is in an IRA, you can take the money any time you want, although you’ll give up tax benefits and possibly pay an early distribution penalty. In a 401k account, you may not be able to take a distribution while you’re still employed at the company that maintains that retirement plan, although many employers allow hardship distributions under specified circumstances.
In some situations you may want to borrow from your retirement account. This is not allowed at all for IRAs. Many employers allow workers to borrow from their 401k or 403b accounts, though. This isn’t necessarily good financial planning, but can be a way to get through a short-term crunch without depleting your account.
Minimum distribution rules
The minimum distribution rules that apply to traditional IRAs don’t apply to Roth IRAs other than those that are inherited from someone other than a spouse. This is a big advantage for people who don’t need to draw down their IRAs as fast as those rules would require. The longer you can keep your money in an IRA, the better. The minimum distribution rules do apply to Roth accounts in 401k or 403b plans, but this is not a significant problem. When you retire, you can roll your Roth 401k or 403b account into a Roth IRA where the minimum distribution rules won’t apply.
If you contribute to a Roth IRA, you can change your mind later about the type of IRA that received the contribution. This is called a recharacterization. The main purpose of this rule is to help people who learn after contributing to a Roth that their income is too high to permit that contribution. Yet a recharacterization can be used for other purposes. For example, you may simply find that the deduction you would get from contributing to a traditional IRA is more valuable than you anticipated, and choose to recharacterize the contribution for that reason.
This type of recharacterization is still permitted despite repeal of the rule that permitted the use of recharacterizations to undo post-2017 conversions.
When you contribute to a 401k account, your choice between a traditional account and a Roth account is irrevocable. You can change your choice for future contributions, but you can’t undo your choice for contributions you already made as you can when you contribute to a Roth IRA.
The five-year requirement to obtain qualified distributions from a Roth account in a 401k or 403b plan is similar to the requirement for Roth IRAs, but there are important differences. You should be aware that different Roth 401k or 403b accounts can have different holding periods, and in a rollover to a Roth IRA, the aging of the 401k or 403b account does not carry over to the IRA.
If you take a nonqualified distribution from a Roth IRA, your contributions come out tax-free before you have to pay tax on distributions of earnings. If you take a nonqualified distribution from a Roth 401k or 403b account, part of that distribution will be taxable (based on the portion of the account that represents earnings) even before you’ve withdrawn all your contributions.