While digging into IRS rules about retirement accounts might seem wonky or something only a CPA should know, I promise it's worthwhile.
Laura answers a listener’s question about the differences between a Roth IRA and a Roth offered at work. You’ll learn the updated rules and whether a traditional or Roth is best for you.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Hi friends, and welcome back to Money Girl! My name is Laura Adams. If you're new here, I'm an award-winning personal finance author who's been writing and hosting this show since 2008. If you're interested in being your own boss or want to take your small business to the next level, check out my latest title, Money-Smart Solopreneur–A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers. It's available as a paperback, ebook, or audiobook wherever books are sold!
To learn more about my other books, debt, and credit online money courses, or how to work with me, visit my personal website, LauraDAdams.com.
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I recently received an email from Faith F., who said, "What's the difference between a Roth 403(b) and a Roth IRA?"
Thanks for sending in this question, Faith! I know Roth rules can be confusing, which is why I get loads of questions about them.
While digging into IRS rules about retirement accounts might seem wonky or something only a CPA should know, I promise it's worthwhile. When you know the rules for using a retirement account at work or on your own, you have powerful knowledge for building wealth in the easiest way possible.
This episode will explain the similarities and differences between a Roth IRA and various Roth accounts you may be eligible for at work. Plus, we'll cover how to know if using a traditional or Roth account is best for you in the first place.
Related: 7 Changes to Retirement Accounts in 2023 You Should Know
Let's start with the fundamental difference between traditional and Roth retirement accounts. Traditional accounts, such as a traditional IRA or 403(b), allow you to make pre-tax contributions. They're deductible because they get deducted or subtracted from your taxable income for the year, cutting your tax liability. However, withdrawals of traditional contributions and earnings are taxable in retirement.
Roth accounts, such as a Roth IRA or Roth 403(b), require nondeductible, after-tax contributions. So, you don't get any tax benefits in the current year. However, withdrawals of your contributions and earnings are both entirely tax-free in retirement.
The benefits of a Roth retirement account are a big deal because you could have decades of growth that never gets taxed! That's different from a traditional account, where your investment growth only gets deferred until you make a distribution.
Whether you should choose a traditional or Roth retirement account depends on how badly you want a tax deduction now versus paying tax on your contributions. In general, using a Roth makes sense if you believe your income or tax rate will be higher in the future when you take withdrawals. In other words, paying tax upfront on less income is better.
But if you believe your retirement income or tax rate will be lower, deferring it with a traditional retirement account may be best. You'd pay tax in the future when you take distributions. And if you're unsure what the future may hold, you can split contributions between traditional and Roth accounts, which is always a smart money move.
Faith asked specifically about a 403(b), which is a sister account to the 401(k). Each offers qualified employees a tax-advantaged way to invest for retirement using a traditional or pre-tax account, a post-tax or Roth account, or a combination of both.
A 403(b) and a 401(k) have basically the same rules. For instance, the updated 2023 contribution limit for both is $22,500 or $30,000 if you're over 50. Each allows you to withdraw funds penalty-free after the age of 59.5. And they both allow Roth options.
While a 401(k) is available to private-sector company workers, a 403(b) is only for tax-exempt organizations, like public schools, state universities, hospitals, and churches. If your employer offers both plans, you can use both if your total contribution doesn't exceed the annual limit I mentioned.
Related: Your Complete Guide to 401(k) Retirement Accounts
An IRA is also a tax-advantaged way to invest for retirement but is available to anyone with earned income or a spouse with earned income if you don't work. While there are no income limits to qualify for a pre-tax, traditional IRA, high earners aren't allowed to make post-tax Roth IRA contributions.
After several years of no increases, the 2023 IRA contribution limit will be $6,500 or $7,500 if you're over 50 for a traditional IRA, Roth IRA, or a combination of both.
Additionally, the annual modified adjusted gross income (MAGI) limits to qualify for a Roth IRA are higher in 2023 as follows:
The higher income limits are terrific because more people will qualify for these valuable accounts that skip taxes on investment growth and give you tax-free income in retirement. Note that you can max out both a Roth IRA and a workplace retirement plan in the same year without the tax conflicts that exist for a traditional IRA.
Now that you understand workplace and individual retirement accounts, I'll answer Faith's question and review ten ways a Roth 403(b) differs from a Roth IRA.
1. Eligibility rules.
The first way a Roth at work and a Roth IRA differ is who's eligible for one. You can only have a Roth 401(k) or 403(b) if your employer offers it. But anyone with earned income that doesn't exceed the annual limits I covered, including minors and seniors, can have a Roth IRA.
2. Spousal benefits.
One great feature of traditional and Roth IRAs is that you qualify if you don't have an income, but your spouse does. Whether you're unemployed, a stay-at-home parent, or run your own part-time business, it doesn't matter. A breadwinner can fund an IRA for their non-working spouse. That's never allowed with workplace retirement plans because they're only available for employees.
3. Contribution limits.
I also reviewed the annual contribution limits, which vary significantly between a workplace retirement plan and an IRA. You can stash away much more in a Roth 403(b) or 401(k) than in a Roth IRA.
Again, for 2023, workplace plans allow you to contribute up to $22,500 or $30,000 if you're over 50. But IRAs only allow up to $6,500 or $7,500. That's why you should always max out an employer's retirement plan before investing in an IRA.
4. Employer matching.
In addition to high contribution limits, workplace retirement plans typically have another huge advantage: matching funds. Often, employers incentivize workers to participate in their retirement plans by matching their contributions to a percentage.
For instance, your company might deposit 50% of your contributions up to 6% of your salary. That's free money that you should always be sure to max out!
Note that matching funds are always pre-tax, so they get deposited into a traditional account on your behalf. So, if you're contributing to a Roth 403(b), any matching funds you receive will be in a traditional 403(b) rather than your Roth account.
5. Income limits.
The fact that a Roth IRA is the only retirement account with income limits gets misunderstood. No income limits exist to qualify for a traditional IRA or any workplace retirement account. That means you can have a Roth 403(b) or 401(k) even if you're the highest-earning worker at your company.
Remember that you become ineligible to make Roth IRA contributions as a single taxpayer with income over $153,000 or a joint filer over $228,000.
6. Investment options.
Another difference between IRAs and workplace retirement plans is how you can invest your contributions. Theoretically, with an IRA, you can choose any mainstream investment, including stocks, bonds, mutual funds, exchange-traded funds, and cryptocurrencies. Some self-directed IRAs allow you to invest in physical assets, like real estate and businesses.
In a workplace retirement plan, participants are limited to the investment menu offered by their employer. However, for average investors, that's not a downside that should keep you from using one. In fact, it could help you focus on mainstream investments and stay away from potentially riskier ones.As I mentioned, maxing out your workplace retirement plan comes with multiple benefits, including high contribution limits and potential employer matching.
7. Early withdrawals.
The rules for taking early withdrawals are similar for Roth workplace retirement plans and Roth IRAs. For both, withdrawals are tax-free if you've owned the accounts for at least five years, reached age 59.5, or experienced a disability.
If you have a Roth 403(b) or a Roth IRA and are younger than 59.5, taking a distribution means paying a 10% early withdrawal penalty and taxes on non-contributions, which are the earnings portion of your withdrawal. There are no taxes or penalties on your contributions because you paid tax upfront on them.
However, with a Roth IRA, there are certain situations when you can avoid taxes and penalties on early withdrawals. For instance, if you’ve owned the account for five years, you can withdraw up to $10,000 to buy or build a primary residence, all while avoiding taxes and the 10% penalty on your withdrawn earnings portion.
8. Taking loans.
With either a traditional or Roth IRA, no loans are allowed; however, it may be an option at work. Most 401(k) and 403(b) plans allow you to borrow up to 50% of your vested account balance, up to $50,000.
However, taking a 401(k) or 403(b) loan means you must repay yourself with interest within five years, usually with payroll deductions. While that helps you make up for lost time, failure to repay on time is the same as an early withdrawal, subject to taxes and the 10% penalty on the earnings portion.
The main downside of borrowing from your 401(k) or 403(b) is that if you leave your job or get terminated, you typically have 60 days to repay the entire outstanding balance. Plus, you also often aren't allowed to make new account contributions until the loan gets paid off.
Always use a 401(k) loan calculator to determine how much you can or want to borrow. In some cases, using another type of loan, such as a low-interest personal loan, may have fewer risks.
9. Required minimum distributions (RMDs).
Many people don't understand that required minimum distributions with a workplace Roth and a Roth IRA have different rules. With a Roth 401(k) or 403(b), you must take IRS-mandated RMDs starting at age 72. However, with a Roth IRA, there are none.
The best way to avoid having to make distributions if you want to keep your money invested is to roll over your workplace Roth to a Roth IRA, which doesn't trigger taxes or penalties. Since you can keep money in a Roth IRA indefinitely, it's an excellent vehicle for passing money to your heirs.
10. Retiring early.
An IRS provision known as the rule of 55 allows workers who leave their jobs for any reason to take penalty-free retirement account distributions at age 55. That will enable employees who want to retire ahead of schedule or take an early retirement package an option for getting income before age 59.5.
But the rule of 55 doesn't apply to traditional or Roth IRAs. Remember that if you've had a Roth IRA for at least five years, you can withdraw your original contributions without paying taxes or penalties, no matter your age.
As always, you can leave a comment or money question by calling 302-364-0308 to leave a voice message. Or send an email using my contact page at LauraDAdams.com.
That's all for now. I'll talk to you next week. Until then, here's to living a richer life.