The ERISA consultants at the Columbia Management Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. A recent call with an advisor in Massachusetts is representative of a common inquiry involving Roth IRAs vs. designated Roth contributions in 401(k) plans. The advisor asked:
“What are the differences between Roth IRAs and designated Roth 401(k) accounts?”
The following summarizes the key differences.
Investment Options
• Roth IRA: Generally, unlimited except for life insurance and certain collectibles.
• Designated Roth 401(k): As specified by the plan.
Eligibility for Contribution
• Roth IRA: Must have earned income under $127,000 if single tax filer; under $188,000 if married filing joint tax return.
• Designated Roth 401(k): 401(k), 403(b) or governmental 457(b) plan with designated Roth contribution option; individual must meet eligibility requirements as specified by the plan.
Contribution Limit
• Roth IRA: $5,500 ($6,500 if age 50 or older).
• Designated Roth 401(k): $17,500 ($23,000 if age 50 or older).
Conversions
• Roth IRA: Anyone with eligible IRA or employer- plan assets may convert them to a Roth IRA.
• Designated Roth 401(k): Plan permitting, anyone with eligible plan assets may convert them within the plan.
Recharacterization of Conversion
• Roth IRA: Yes, within prescribed time frame.
• Designated Roth 401(k): No.
Required Minimum Distributions
• Roth IRA: Not during owner’s lifetime.
• Designated Roth 401(k): No.
Tax-free Qualified Distributions
• Roth IRA: After five years and age 59-1/2, death, disability or for first home purchase.
• Designated Roth 401(k): Must have distribution triggering event; then after five years and age 59-1/2, death or disability.
Tax on Nonqualified Distributions
• Roth IRA: According to distribution ordering rules: (1) Contributions — always tax- and penalty-free; (2) conversions — on a first-in, first-out basis by year, always tax-free, possible penalty on taxable-at-conversion assets taken within five years of conversion; (3) earnings — taxed as ordinary income, subject to penalty unless exception applies.
• Designated Roth 401(k): Withdrawals represent a pro rata return of contributions and earnings in account; earnings taxable and subject to penalty unless an exception applies. See IRS Notice 2010-84 for rules applicable to the return of designated Roth 401(k) converted amounts.
Timing of Distributions
• Roth IRA: At any time.
• Designated Roth 401(k): Following plan defined distribution trigger.
Loans
• Roth IRA: No.
• Designated Roth 401(k): Yes, if plan permits.
Five-year Holding Period for Qualified Distributions
• Roth IRA: Begins January 1 of the year a contribution is made to any Roth IRA of the owner.
• Designated Roth 401(k): Separate for each designated Roth 401(k) account; begins January 1 of the year a contribution is made to that account.
Beneficiary
• Roth IRA: Anyone, but spousal consent required in community property states.
• Designated Roth 401(k): Anyone, but spousal consent is required.
Conclusion
While both Roth IRAs and designated Roth 401(k) plan contributions offer the potential for tax-free withdrawals, there are several key differences between the two arrangements. Financial advisors who can demonstrate their knowledge of the differences set themselves apart from the average advisor and are better positioned to help their clients maximize their retirement savings contributions.
The Columbia Management Retirement Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC, a third-party industry consultant that is not affiliated with Columbia Management. For informational purposes only. Please consult a tax advisor or attorney for specific tax or legal needs. © 2013 Columbia Management Investment Advisers, LLC. Used with permission.
