How To Choose Between A Roth 401(k) And A Roth IRA


Traditional 401(k)s offer upfront tax savings and tax-free buildup.

But withdrawals will be taxed. That can be painful if future tax rates are higher than today's.

Roth accounts offer an alternative. They don't give an upfront tax break. But all withdrawals are tax-free after you've had the account five years and reach age 59-1/2.

If the prospect of tax-free income cinches the argument for you, you might have two Roth options. If you're at least 59-1/2 and if your plan offers a Roth version and allows in-service conversions and distributions, you can choose to convert to your Roth 401(k) or a Roth IRA without penalties.

If you can't do an in-company conversion, other paths to a Roth exist.

To make your decision, it helps to get a handle on the differences between the two types of accounts. And there are several:

• Roth IRAs. They have no required minimum distributions during the owner's life.

You can withdraw as much or as little as you want in retirement. Or you can avoid all distributions to leave a large tax-free fund to your beneficiaries.

"It's easier to get your own contributions back tax-free from a Roth IRA than from a Roth 401(k)," said attorney Natalie Choate of the Nutter McClennen & Fish firm in Boston. Distributions from a Roth IRA are first in, first out.

If you haven't passed the five-year and age-59-1/2 tests, you withdraw after-tax contributions first.

With a Roth 401(k), premature withdrawals are treated as partially after-tax and partially taxable, based on how much of the balance is from after-tax contributions.

One key difference: "You can change your mind about a Roth IRA conversion," Choate said.

Until Oct. 15 of the next year, you can reverse all or part of the transaction. The amount you switch back is re-characterized to a traditional IRA.

Say you convert a $100,000 traditional IRA to a Roth IRA this year. Then a market slump reduces your IRA to $80,000.

You can undo the conversion any time until Oct. 15, 2014. You won't pay tax on $100,000 of income to get an $80,000 Roth IRA.

Roth 401(k) conversions have no such annulment option.

What's more, you likely have more investment flexibility with a Roth IRA. You may have a limited menu with a Roth 401(k).

• Roth 401(k)s. Why should you convert to them instead?

Availability, for starters. You can convert all or part of your traditional 401(k) to a Roth version at any time, regardless of age. That's true as long as you're in any of the 49% of 401(k) plans that offer Roth options and allow in-plan conversions.

Conversions to a Roth IRA often must wait until you leave the company or reach age 59-1/2. So young workers can get an early start on tax-free buildup with a Roth 401(k).

Creditor protection is another feature. Employer-sponsored plans generally are better protected against lawsuits and bankruptcy creditors than IRAs. That protection extends to a Roth 401(k).

And Roth 401(k) plans may let you borrow from your account. Borrowing from a 401(k) has drawbacks, but it can be helpful to have a no-hassle source of ready cash.

"In addition, some 401(k) plans offer access to attractive investment options that are not widely available," Choate said. Those can include private equity deals.

And with a Roth 401(k), your boss might match your contributions.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , Mutual Funds

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