Orman: Why a Roth IRA Is Not a Roth 401(k)

I am loving connecting with thousands of you via Twitter (come join the fun: click here).

But what I am not loving is my growing sense that a lot of you are getting lousy financial advice. Today I exchanged tweets with someone who has bad info on how Roth 401(k)s work. Roth 401(k)s are a fantastic way to save for retirement, but they do not work exactly the same as a Roth IRA.

Quick Recap of Why I love Roth IRAs.

Anyone who’s been listening to me knows all about the fabulous Roth IRA. With a Roth you forego an initial tax break on the money you contribute; that is you invest with after-tax dollars. So what’s so alluring? The fact that when you go to make withdrawals in retirement you will not owe one penny of income tax assuming you are at least 59 1/2 and have had the IRA for at least five years. That’s a lot different than a traditional IRA; every penny you withdraw in retirement is taxed at your ordinary income tax rate. And as I have told you many times, a Roth IRA can also be a useful emergency fund; the money you contribute (but not the earnings) can be withdrawn at any time without any tax or penalty regardless of your age or how long the money has been in there. That’s because you invested after-tax money. While I want everyone to keep retirement money invested for retirement, the fact that the Roth IRA gives you some flexibility for emergencies is another nice feature.

Enter the Roth 401(k).

While the Roth IRA became available in 1998 it wasn’t until 2006 that the Roth 401(k) arrived on the scene. Not every company offers a Roth, but if your employer does, I think they deserve a serious look-see. Just like a Roth IRA, with a Roth 401(k) you invest after-tax money, so there’s no initial tax break on your contribution. But you get the same eventual payoff: in retirement if you have had the account at least five years and you are at least 59.5 all withdrawals from a Roth 401(k) are 100 percent tax free. Meanwhile, withdrawals you make from a Traditional 401(k) will always be taxed at your ordinary income tax rate. Imagine what that could be given our current deficits.

Okay, so up to this point the Roth IRA and the Roth 401(k) are identical twins in how they work tax-wise.

But here’s an important difference: Even though you invest after-tax dollars in your Roth 401(k) there’s not the same penalty-free way to withdraw Roth 401(k) contributions if you are younger than 59 1/2, as you can with a Roth IRA. In essence, the “emergency savings feature” you have with a Roth IRA does not work the same way with a Roth 401(k).

Here is how early withdrawals from a Roth 401(k) are treated by the IRS: Let’s say you contributed over a 3 year period just $8,000 to your Roth 401K. Lets also say that over those three years your ROTH 401k grew to $10,000. So $2,000, or 20 percent, of your account balance is the earnings portion of your Roth 401k , and $8,000 is from your contributions. The 20 percent is the important figure here. Now let’s say you need to take $8000 out of your ROTH 401k. Here is how it will work. When you withdraw $8000, 20 percent of the $8000 or $1600 would be taxed as ordinary income and if you were not at least 59.5 years of age at the time of withdrawal you would also owe a 10 percent penalty on that $1600 as well.

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So that is a big difference between a Roth IRA and a Roth 401(k). With a Roth IRA you could have withdrawn $8,000 of contributions penalty-free regardless of your age. With a Roth 401(k) there is no way to designate that you only want to withdraw from contributions.

I also want to clear up another common Roth 401(k) misconception. If you receive a matching contribution from your employer to your Roth 401(k), the match works like a traditional 401(k): the money that is invested on your behalf by your employer goes into a traditional 401(k), so when you retire and go to make withdrawals you will owe income tax on money taken from your “matching” account. And just to be clear: if you are still working for the company and need to make an early withdrawal from your 401(k) account that holds your company match you will owe tax and the 10 percent penalty levied if you are younger than 59 1/2.

Does that make me less enthusiastic about Roth 401(k)s? Of course not! People, the whole purpose of your 401(k) is to save for retirement. And after the big market losses, you need to save more than ever. You don’t choose a retirement vehicle for its raid-ability. My preference will always be a ROTH IRA however if you qualify.

The Roth or the Roth 401(k) is a terrific way to save. Especially now. With our large federal deficits it’s more than likely we are going to see higher tax rates in the future. If you fast forward to retirement and anticipate your tax rate then will be higher than your tax rate today, a Roth or a Roth 401(k) can be a smart way to generate tax-free income in retirement.

So now you know the real scoop on early withdrawals from Roth 401(k)s. If you want more info on Roth 401(k)s check out this site.

And keep in touch. Twitter.com/SuzeOrmanShow

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