Let’s first define the four types of accounts that fall within the discussion comparing features of Traditional and Roth IRA accounts and 401(k) plans. First, there is the difference between an Individual Retirement Account (IRA) and an employer-sponsored retirement plan for it’s employees, the 401(k). Each of these two, the IRA and 401(k), come in the original or, “Traditional”, variety as well as the more recently created “Roth” variety.
Anyone with taxable income can contribute to an IRA, though the tax benefits may be effected for those who also participate in a 401(k) plan. Only those who work for a company that offers a 401(k) plan are eligible to participate in a 401(k), and only if they meet the participation requirements of their employer’s plan. Further, not all employers offer the Roth version of the 401(k), so check your plan to know what it allows.
*Note that self employed or smaller business owners can easily create their own 401(k) plan with the help of an advisor.
Always Consult a Professional
Tax treatment of retirement plans and accounts can be very complex. We are going to speak here under “ordinary” conditions, meaning what each plan/account is specifically intended for, with the understanding that there exists a number of exceptions under a number of differing circumstances that could change things. For example, there are times when untaxed contributions under “ordinary” conditions could be taxed under certain exceptions. It is important that a tax professional or independent financial advisor be consulted in order to make the most informed decisions.
Tax Treatment of Contributions Made by the Participant
The defining difference between “Traditional” and “Roth”, be they of the 401(k) or IRA varieties, is that contributions to the traditional accounts are not taxed in the tax year for which the contribution is made. Hence the account holder will receive a tax deduction that year for the amount contributed. Contributions to Roth accounts are made on an after-tax basis, meaning that taxes on the contribution are paid in the tax year of the contribution.
Tax Treatment of Investment Income inside the Account
Contributions earn investment income within the retirement account in the form of appreciation, interest income, dividends, etc. (from stocks, bonds, mutual funds, CD’s, etc.). Under both the Tradition and Roth 401(k) and IRA, investment income is not taxed while it is earned and remains in the account. Investment income grows tax-free in all four types of these accounts. Taxation differences arise later, when withdrawals are taken.
Tax Treatment of Withdrawals of Contributions at Retirement
When withdrawn properly in accordance with tax law, contributions from Traditional 401(k)s and IRAs, contributions that went untaxed in the year they were made, are taxed as ordinary income. This is why we call it “tax-deferred”, because taxes are eventually paid.
Unlike the Traditional accounts, properly withdrawn contributions from either type of Roth account are made tax-free. Remember, their contributions were already taxed in the year they were made, so this is to avoid an unfair double taxation. Also, note that we are talking only about the contributions, not the investment income earned on the contributions (see below).
Tax Treatment of Withdrawals of Investment Income
This is where we see the big distinction between the Traditional and Roth accounts. Remember that with both types of accounts, taxes are paid on the contributions made by the account holder. It’s just a matter of whether they are paid at the time of contribution (Roth) or at the time of withdrawal (Traditional).
With the Traditional IRA and 401(k), investment income is taxed as ordinary income at the time of withdrawal. It is also important to note that it is taxed as ordinary income and not as capital gains income as investment income outside of retirement accounts is most often taxed. Ordinary income tax rates are usually higher.
With the Roth IRA and Roth 401(k), properly withdrawn investment income is not taxed. And because it is also not taxed as it grows within the account, this means that investment income within the Roth type accounts is never taxed. This is the most important distinction between the two types of accounts, Traditional and Roth.
Though contribution limits are different between IRA accounts and employee-sponsored 401(k) plans, they are the same, with a few exceptions, for the Traditional and Roth versions within IRAs and 401(k)s. The primary exception is that, for the IRA versions of these accounts, Roth contributions are phased out and then eliminated for individuals with high earnings. See our coverage in other articles linked to below for more details.
Employer Matching Contributions
Because there is no employer involved with Individual Retirement Accounts, there can be no employer matching contributions. With 401(k) plans, employers may choose to match employee contributions to varying degrees and under a number of conditions as outlined in the specific plan of each employer.
Employer Matching Contributions in Roth 401(k) are Tax-Deferred
It is important to note that employer matching contributions in a Roth 401(k) are not treated the same as the employee contributions. Employer contributions are made pre-tax just as they are in a Traditional 401(k). As such, they must be held in a separate account to ease with the administration of taxes at the time withdrawals are taken. Employer matching contributions to a Roth 401(k) and investment income on those contributions are taxed as ordinary income at the time of withdrawal.
When Can Distributions Begin?
With all four types of accounts, distributions can begin penalty-free starting at age 59 1/2. With Roth accounts, another condition must be met, that of the “five year seasoning rule”. The account must have been opened for at least five years prior to the first withdrawal.
Exceptions exist for cases of disability and early termination of employees who are over 50 years of age and it’s important to consult a tax professional or independent financial advisor for the most accurate advice.
Tax law requires that distributions must be made starting at the age of 70 1/2 for the Traditional IRA, Traditional 401(k) and Roth 401(k). Only the Roth IRA requires no forced distribution at any age.
Loans Taken From Retirement Accounts
No loans are allowed from either the Traditional or Roth IRA accounts. If an employers’ plan allows, loans may be available from Individual or Roth 401(k) accounts while still employed with the employer that set up the account. Consult a tax professional to learn the specific details of your plan and qualifications.
Note that there are several exceptions that might allow for normally penalized early withdrawals to be made without a penalty. However, under normal circumstances, early withdrawals from Traditional 401(k) and IRA accounts incur a 10% early withdrawal penalty.
To understand early withdrawals taken from Roth 401(k) and IRA accounts, we must first remember that contributions were made after taxes had already been paid. Therefore, the portion of early withdrawal designated as having come from a contribution incurs no early withdrawal penalty nor any income tax. However, the portion that is deemed as having come from investment income earned within the account incurs a 10% early withdrawal penalty and is taxed as ordinary income.
Conversions and Rollovers
In general, Roth IRA and Roth 401(k) accounts can never be rolled over or converted into Traditional 401(k) or Traditional IRA accounts. However, under certain circumstances, Traditional IRA and 401(k) accounts can be “converted” into Roth IRA or Roth 401(k) accounts. Note that these conversions will cause income taxes to be paid on the conversion amount, payable in the year of the conversion.
The laws and conditions related to conversions between the different types of retirement accounts are very complex and beyond the scope of this article. As always, it is best to consult with a tax professional or independent financial advisor before taking action.
There are a number of other differences between these accounts that are best discussed with a tax professional or financial planner. Some examples are:
- Eligibility for a home downpayment or when saving a home from foreclosure.
- Possible use of funds for educational expenses.
- Possible use of funds for unreimbursed medical expenses or medical expenses not covered by health insurance.
- Estate planning issues upon death of the account holder vary from plan to plan and from household to household.
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What is a Roth 401(k)?
What is a Roth IRA?
401(k) rollover options when making a job change