Among savers and investors, the terms IRA, 401(k), and Roth are as common as drinking water, and sometimes the lines between them get blurred and the distinctions are lost. I’ve had multiple clients refer to their IRA as their 401(k) because that’s where the money was before it got rolled over. Many people haven’t been able to tell me whether their IRA is traditional or Roth. They just put money into it because someone told them it was a good idea.

 

The distinction gets almost as blurry when you talk about a Roth IRA and a Roth 401(k). No, they’re not the same and just like using any tool in a toolbox, you need to know what the tool was designed to do so you can decide if it’s the right tool for what you’re building.

 

Here are the specifics:

 

401(k)

A 401(k) is offered by an employer to its employees. It’s an easy way to save because the employee can have money withheld directly from their paycheck and deposited into an account.

  • Money going into your 401(k) account is not included in your taxable income
  • The maximum amount you can withhold in 2023 is $22,500.
  • If you are 50 or older you can have an additional $7,500 withheld as a catch-up contribution.
  • You can contribute money to your 401(k) above the tax-deferred maximum but you will be taxed on that amount.
  • Total taxable, tax-deferred, and employer contributions in 2023 can’t exceed $66,000, or $73,500 for those 50 years old and older.
  • You choose how your account is invested among the options available in your employer’s 401(k) plan.
  • Income and capital gains from the investments are tax-deferred as long as they remain in the account.
  • Distributions from a traditional 401(k) are taxed as ordinary income.

 

Roth 401(k)

  • Money going into a Roth 401(k) account is included in your taxable income and you do have to pay taxes on the Roth 401(k) contributions even though you don’t receive the money.
  • The maximum amount you can withhold in 2023 is $22,500.
  • If you are 50 or older you can have an additional $7,500 withheld as a catch-up contribution.
  • Total taxable and tax-deferred contributions in 2023 can’t exceed $66,000, or $73,500 for those 50 years old and older.
  • Employer contributions to a Roth 401(k) will be placed in a tax-deferred account and you will not be taxed on those employer contributions until you take distributions from that account.
  • You choose how your account is invested among the options available in your employer’s 401(k) plan.
  • Income and capital gains from the investments are tax-deferred as long as they remain in the account.
  • Distributions from a Roth 401(k) are not taxed.

 

IRA (Individual Retirement Account)

  • You can receive a tax deduction for contributions to an IRA.
  • Contributions to a traditional IRA are deductible if the IRA owner isn’t covered by an employer retirement plan.
  • Total contributions to all IRAs in 2023 is $6,500.
  • If you are 50 or older you can contribute an additional $1,000 as a catch-up contribution.
  • Contributions, usually, can be invested in any publicly traded asset.
  • Income and capital gains from the investments are tax-deferred as long as they remain in the account.
  • Distributions from a traditional IRA are taxed as ordinary income.

 

 

Roth IRA

  • Contributions to a Roth IRA are not deductible
  • Contributions to a Roth IRA are not allowed in 2023 for single tax filers with modified adjusted gross income (MAGI) above $153,000 or joint filers with MAGI exceeding $228,000.
  • Income and capital gains from the investments are tax-deferred as long as they remain in the account.
  • Distributions from a Roth IRA are not taxed as long as you are at least 59 ½ and the Roth IRA has been open for five years or longer.

 

Now, let’s compare traditional accounts and then Roth options.

 

The 401(k) Vs. The IRA

There are several factors to consider when you’re trying to decide whether to save through an IRA or 401(k) plan.

 

Most employers allow employees to take loans from their 401(k)s. Loans aren’t allowed from IRAs. They’re treated as distributions and will be taxable when taken from a traditional IRA.

An IRA is likely to have more investment options than a 401(k), though the 401(k) might have enough investment choices to meet your needs.

 

An IRA is more flexible. You can move the account to a different custodian whenever you want, in most cases. You also can take distributions whenever you want, though they might be subject to a 10% early distribution penalty in addition to any income taxes if the distribution is before age 59 1/2. Distributions from a 401(k) generally aren’t allowed until you leave the employer, unless there is an in-service distribution option. After that, you can leave the money in the 401(k) account, roll it over to an IRA, or roll it over to the 401(k) plan at a new employer, if the new plan allows it.

 

Most employers match part of the contributions employees make to their 401(k) accounts. This is free money to the employee. It doesn’t reduce regular compensation, and the matching contribution isn’t received unless the employee contributes a qualifying amount to the account. That’s why it’s often a good idea to contribute at least enough to a 401(k) plan to receive the maximum employer matching contribution.

 

Of course, if you want to save a lot of money, you don’t have to choose between an IRA and 401(k). You can save the maximum amount in each type of plan.

 

The Roth 401(k) Vs. The Roth IRA

When you decide you want a Roth-type account, keep in mind that the rules for the 401(k) and IRA aren’t the same. The knowledge will help you decide which type of account to open. It also might influence a decision of whether to keep money in a 401(k) or roll it over to an IRA.

 

The maximum IRA contribution is $6,500 in 2023 with an additional $1,000 catch-up contribution for those age 50 or older. But the maximum deferral to a 401(k), whether Roth or traditional, is $22,500 in 2023 with an additional $7,500 catch-up contribution in 2023 for those 50 and older.

 

There’s also an income limit for contributions to Roth IRAs. The maximum contribution begins to be reduced for a single taxpayer when adjusted gross income exceeds $138,000 in 2023 and $218,000 in 2023 for married couples). There are no income limits for 401(k) contributions.

 

Require Minimum Distributions (RMD)

Many people don’t realize that there are differences in required minimum distributions (RMDs).

  • Traditional IRAs must begin RMDs for anyone turning 73 in 2023. The age goes up to 75 years old beginning in 2033.
  • RMDs are not required for the original owner of a Roth IRA. But after the original owner’s death, beneficiaries of the Roth IRA, excluding a surviving spouse, are required to take RMDs.
  • In 2023, RMDs are required for Roth 401(k)s beginning at age 73, unless the account owner is still working and owns less than 5% of the employer that sponsors the plan. These RMDs are tax-free. Beginning in 2024 and going forward, there will be no RMD requirements for Roth 401(k)s.
  • For traditional 401(k) accounts, retirement plan account owners can delay taking their RMDs until the year in which they retire, unless they’re a 5% owner of the business sponsoring the plan.

 

Other Things to Consider

You can take tax-free loans from a Roth 401(k) under certain circumstances.

 

Loan Limits

The IRS sets the maximum amount you can borrow from your Roth 401(k) plan at the lesser of $50,000 or 50 percent of your account balance. However, these limits are cumulative with your traditional 401(k) loans with the same employer. For example, if you have a $20,000 loan from your traditional 401(k) plan, you could only borrow a maximum of $30,000 from your Roth 401(k) plan with the same company.

 

Repayment Terms

Typically, Roth 401(k) loans must be repaid within five years, and the payments must be substantially equal. For example, you couldn’t repay a token amount of your Roth 401(k) loan for the first three years and then make larger payments over the last two to meet the repayment deadline. However, the IRS does let you take a longer time to repay a loan if it’s used for buying a principal residence. If you need a 401(k) loan for a down payment on your house, you can take longer than five years to pay it back.

 

Tax Implications

Taking a loan from your Roth 401(k) plan doesn’t carry any negative tax implications — as long as you pay it back as agreed. Where people run into tax issues, however, is if they don’t pay it back. If you leave your job, even for circumstances completely out of your control, the entire balance becomes due shortly thereafter, typically within two months. If you don’t repay it, it’s deemed a distribution of the balance of the loan, and the portion of the loan attributable to earnings then becomes taxable and subject to the 10 percent early withdrawal penalty in most cases.

 

You cannot take a loan from an IRA — only distributions are allowed, and there will be a 10% penalty if they are taken before age 59½, unless you qualify for one of the exceptions.

 

Conclusion

Lots of things to know, lots of things to consider as you decide which accounts and which mix of accounts will help you achieve your desired outcome.

 

 

Disclaimer

This information is presented for informational purposes only and does not constitute an offer to sell, or the solicitation of an offer to buy any investment products. None of the information herein constitutes an investment recommendation, investment advice, or an investment outlook. The opinions and conclusions contained in this report are those of the individual expressing those opinions. This information is non-tailored, non-specific information presented without regard for individual investment preferences or risk parameters. Some investments are not suitable for all investors, all investments entail risk and there can be no assurance that any investment strategy will be successful. This information is based on sources believed to be reliable and Alhambra is not responsible for errors, inaccuracies, or omissions of information. For more information contact Alhambra Investment Partners at 1-888-777-0970 or email us at [email protected].