Roth IRA vs Roth 401(k) — 5 Differences That Cost People Money

Welcome everyone to the Directed IRA Podcast. This is Matt Sorensen, excited to share today's episode with you. I break down the Roth IRA versus the Roth 401. They have so much in common, but they have 5 major differences you need to know. I put this out on YouTube and within 1 day I had 100,000 views. Apparently people are interested in this, so I thought, let's share it on the Directed IRA Podcast. Please enjoy. Roth IRAs and Roth 401s actually have more differences than they have in common. Sure, these accounts have the same first name and they both have tax-free growth and tax-free distributions, but almost everything else about them is different. And there are 5 differences in particular that I'm going to walk you through in this video. And these differences are some of the most important rules that apply to retirement accounts, from contribution rules to high-income restrictions to backdoor methods to early distribution rules and to rollover and transfer rules and even the 5-year rule. These are all different. But when you understand the differences, you'll know how to take advantage of every ounce of tax-free growth from each account. Or you could determine which of the 2 accounts is best for you. 'Cause it's not just about which account is better, it's which account is better for the specific dollar you have that you're about to contribute. Because the answer changes based on your income, your employer if you have one, how much you're putting away, and when you might need the money back. So here's the plan: 5 side-by-side comparisons and then a quick decision cue after each one And then the funding order that gets most people the best of both accounts. I'm Matt Sorensen, tax attorney and CEO at Directed IRA. My company has set up over 20,000 Roth IRAs and Roth 401s for retirees, and I've learned what matters and how to best take advantage of Roth strategies for your IRA or 401. So let's break it down. So let's get into eligibility rules and let's talk about Roth IRAs first. The nice thing about Roth IRAs is anyone who has earned income can establish a Roth IRA. Now, earned income is like wage income, self-employment income. Earned income, by the way, is not rental property income or capital gain income. So just make sure you have earned income. If you do, you can establish a Roth IRA. But there's a catch. If you are a high-income earner making more than $153,000 single or $242,000 married filing joint, or head of household, you cannot contribute fully to a Roth IRA. You can't make a regular Roth IRA contribution. You must do a backdoor Roth IRA. I've got plenty of videos on how to do that. We'll talk about that here a little bit later, but just know the Roth IRA is open to everyone. I don't need an employer for it. I just need earned income. Now, an important point on the earned income too is if you are a non-working spouse but you're married, And you have a spouse that has earned income, you can attribute the working spouse's income to your income and contribute to a Roth IRA. All right, now let's talk about the Roth 401 here. Roth 401s are only available to you if you work for a company that has a 401 plan that allows for Roth contributions. Now, the vast majority of 401 plans in America now allow Roth accounts. It's somewhat newer in the retirement system, but by now, it's been around for 20, 30 years. Roth accounts can be and are mostly available in 401 plans. The great thing though about Roth 401s is there's no high income limit. If you're making $500 grand a year, you are not restricted from contributing to a Roth 401. There's no backdoor method required. You can simply contribute to the Roth 401. making your employee contributions, which is $24,500. We'll get to the full amounts here in a second, straight into the Roth 401 account. Now, there's 2 important things I want to point out here, because this is mistakes that can cost you on this Roth IRA versus Roth 401. There is an excess contribution penalty of 6%. If you contribute to a Roth IRA and you didn't fix it in time, But you made too much money, you weren't allowed to contribute to a Roth IRA. Well, you get penalized for that. And the flip side of this is also people who were told they can't have a Roth IRA when in fact they could have used a Roth 401 or done a backdoor Roth IRA even though they were high income and phased out on the income limits. So just knowing the strategies and understanding the difference matters a lot in how you're getting your money in and understanding the options about whether you can use the Roth 401 or the Roth IRA. But I want to make sure you understand this: I don't care your income limit. You're a high-income earner, you can do a Roth IRA. We're just going to go backdoor. And remember, even if you're high income, you can do the Roth 401. So don't take yourself out of the Roth party because you think you make too much money. I want you to party with all the other Roth people, okay? We can still do the Roth IRA, we're doing backdoor, or the Roth 401. So here's the decision-making on this first point here. If you're high income, I mentioned the amounts earlier, you can still do the Roth 401. And if you wanna do the Roth IRA, we're just doing a backdoor Roth IRA. The second difference between Roth IRA and Roth 401 is how much money we can get in and whether we get some free money that's not our money going into the account. Now, this is the biggest gap between the 2 accounts, and it's not even close. It's more than 3 to 1. In 2026, here's the contribution rule amounts. In a Roth IRA, you can put in $7,500 a year plus $1,100 if you're age 50 plus, meaning I can get $8,600 if I'm age 50 plus or older. And in a Roth 401, you can put in $24,500 a year. That's about 3 times as much. as you can do in a Roth IRA. You also get to put more money in if you're age 50 or older, an extra $8,000. And there's this new super catch-up that came into effect this year. This is for people age 60 to 63 who get to put in an additional $3,250, meaning you could be putting in $35,750 a year of Roth dollars into your 401 if you're age 60 to 63. Again, to keep it simple here, just remember $24,500. Everyone can at least put $24,500 into their Roth 401. Now, the most important distinction on a Roth 401 actually isn't the dollar amount you can put on. It's something called the match. Most 401 plans, including 403 plans that have Roth accounts, allow for something called the match where where the employer incentivizes you to contribute to the 401. And if you're contributing to the 401 with your money, they match and put money in from the company into the 401 for you. So for example, a 4% match would be common. It's a simple calculation here. Let's say you made $100,000 a year and you put in $4,000 into your Roth 401. Well, the company would match that dollar for dollar, putting in $4,000 of their money into the account. So now I've got $8,000 into my 401. Only half of that was my money. I doubled my money and got 100% return on day one. If you're someone with a company that offers a match, you should absolutely take advantage of the match. Contribute with your Roth 401 dollars, Go Roth, we want that tax-free growth. And then the match is going to come in. Now, an important distinction here. Many companies, when they put in the match, they're going to throw those dollars in as traditional 401 or pre-tax dollars. There are some companies that will put it in as Roth, but the vast majority, even though you did Roth contributions, the match is going to come into a separate pre-tax or traditional 401 account. Now, if you're someone that's making, let's say, $100,000 a year and your budget is to put $4,000 or $5,000 into a Roth account, you would be foolish to drop that into a Roth IRA instead of using the Roth 401 because the company will do the match and I would effectively double my contribution on day one. That is the greatest return. You'll find no other investment that will guarantee you a doubling 100% return in year one. Make sure you're taking advantage of the match. If you have a Roth 401, put in enough money to get the full match. Now, what we do after that is very different. This is where we will go back to the Roth IRA and contribute to the Roth IRA for other reasons we'll get to here in a second. And if you're a high incomer and you're like, Matt, I wanna put away as much Roth dollars as possible, go max out that 24.5% in the Roth 401. Do the $7,500 in the Roth IRA. You're probably gonna do a backdoor Roth IRA. If you're married, do a backdoor Roth IRA for your spouse. Let's get as much Roth dollars working as possible. But there is an order of it. And the order of it is first, get the match at your employer, get out, go back to the Roth IRA next for the next $7,500. 'Cause I have more investment options in a Roth IRA. I'm not restricted to the 401 plan menu of mutual funds. or target date funds after I've dropped the $7,500 in the Roth IRA, then go back to the Roth 401 to get the rest of that $24,500 in there. Then I would go back and look at maybe doing a backdoor Roth IRA for your spouse. The 3rd difference between Roth IRAs and Roth 401s is how you can access your money early before age 59 and a half. The flexibility of Roth IRAs are significant But Roth 401s, not so much. And this is where the rules get very different. In a Roth IRA, when I put my money in, and let's say I'm putting $7,500 in a year as my annual contribution, and I've done it for 10 years, I've got $75,000 of contributions. Maybe I'm age 45 right now. But the account, because of investments, is actually worth $125,000. I've had $50,000 of growth. Well, you can pull your contributions that you put into your Roth IRA out at any time, no tax, no penalty. It's only the earnings and growth that you have to wait until you're 59 and a half. So if I wanna buy a home, I wanna go back to school, I need to pay off high-interest debt, I wanna go on a vacation, whatever your reason, wanna be smart here about these dollars, but whatever your reason, you can pull the money out of the Roth IRA before 59 and a half. Without claiming any excuse. It's your money to access. The contributions are always yours. Only the earnings and growth— in the example I gave, the $50,000— have to wait until you're 59 and a half. But when we contrast this with the Roth 401, there's no such rule. When I put money into a Roth 401, that contribution is locked up until 59 and a half. I do not get to pull it out early. The Roth 401 does have a different mechanism though, to get money out if you need it. In a 401, including a Roth 401, you can do something called a participant loan where you lend yourself half the balance of the 401, not to exceed $50,000, and you pay it back over 5 years. So for example, if I had a 401 with $200,000 in it, I can take half the balance not to exceed $50,000. So I could take $50,000 out. On the other hand, if I had an $80,000 401, I can take half the balance, not to exceed $50K. Half the balance in this would be $40,000. Now you're paying it back with at least quarterly payments. You could do monthly, but you're paying it back over a 5-year window at an interest rate of prime plus 2%. But that interest is being paid back to your 401. Again, it's a way to access these dollars and then get 'em back to the 401. So early access, no penalty, no distribution. That's how I'm gonna get it out of a Roth 401 is via this participant loan. Let's just go over a quick example here. Let's say you're 35 years old and you have $40,000 of Roth IRA contributions. Well, that $40,000 in the Roth IRA operates as kind of like an emergency fund of last resort. We can access that money if we need to, but that same 40 grand in a Roth 401, It's locked up. There is a loan workaround and it's a good one. And I can get half the balance of that 401, maybe with growth now it's worth $60,000 and I could borrow out $30,000. But remember, I've got to repay it and get the money back. I'm paying interest, it's going to me, so I don't hate that, but I've got to get the money back into the Roth 401 within 5 years or it is an early distribution subject to tax. And to penalty. So as you're thinking about Roth IRA versus Roth 401, in terms of getting the money back before retirement, the Roth IRA wins. It's better for early savers, younger savers who might need access to the money earlier, because remember, we can get the contributions back whenever we want, whether that's for a new home, to seed a business, some emergency expense we have, or to pay off high-interest debt. The Roth IRA just has more flexibility that is worth real dollars. The 4th difference between a Roth IRA and a Roth 401 is what you can invest it into. This is massive. This is the whole purpose of having a Roth IRA or Roth 401 is investing it, getting tax-free growth and later tax-free distributions. Now, they both have that same tax-free wrapper around them, but what you can invest them into and how they can grow are very different. The Roth 401 is usually restrictive on what you can invest it into. Not because of the law, but because of the plan that you have and your employer restricting your 401 to certain mutual funds or target date funds that your employer or their advisor has selected. And this might be 15 to 30 different funds. And this is usually determined based on a questionnaire you fill out saying your age, the time you want to retire, and whether you want to take high growth, low growth, high risk, low risk. And then they just put you into specific funds. based on how you fill out that questionnaire. Now, you can also choose specific funds and override those decisions, and you want to be proactive in your Roth 401. But the bottom line is here, you get a small menu of what you can invest into with a Roth 401. In a Roth IRA, on the other hand, you can choose the custodian, whether this is a brokerage IRA, a self-directed IRA. And if you're in a brokerage IRA, you can pick whatever stock or index fund you want. You can pick individual companies, buy certain shares. You have lots of options in a brokerage IRA, or you could even go more full architecture with a self-directed IRA, what we do at our company, Directed IRA, where your Roth IRA could be invested into real estate or into a startup or a private fund, notes, crypto, assets you actually know and believe in and think will perform better than, let's say, the stock market. But the Roth IRA, because you are in charge of it, It's an individual retirement account. You are not subject to an employer giving you a menu and forcing you to certain investments that you have to make with the account. You are in charge when it's in an IRA. You can choose the custodian and you can choose the investment options you want to grow and build your tax-free account. The bottom line here between Roth IRA and Roth 401 is the Roth IRA gives me greater ability to choose the investments, have a broader opportunity, And I'm typically gonna have lower fees on the Roth IRA than you are on dollars in your Roth 401. So in this category, I would say the Roth IRA wins out big time. And just a quick pause here, 'cause I just wanna say at this point, if you are the kind of person who likes to be in control of your retirement, I put together a free beginner's guide on how you can self-direct your IRA, not just picking your own stocks with a brokerage IRA, but investing your retirement accounts in assets you actually know, Like the rental property down the street, a private fund, a startup, a private company, crypto. This guide walks you through it step by step. The link is in the description below. And the 5th difference here is how the money can move via rollovers and transfers. This is vastly different for Roth IRAs than it is for Roth 401s. The important thing to understand here is that when you have a Roth IRA, You can only move that money to another Roth IRA. I want you to understand that Roth IRAs are always Roth IRAs. On the other hand, if you have a Roth 401, I can roll that over to a Roth IRA, to another Roth 401. Roth 401s can go into either Roth IRAs or Roth 401s, but Roth IRAs Cannot go to a Roth 401. It's a stupid, weird rule in the tax code. Congress has tried to fix it. It's just people haven't made a big enough fuss about it, so it hasn't changed. And I've seen many clients make this mistake where they've wanted to have a Roth 401, maybe even a Roth Solo 401. They've rolled old employer Roth 401 dollars into a Roth IRA, and now They're stuck. They can't roll that Roth IRA into the Roth Solo 401 because once it hits a Roth IRA, it stays a Roth IRA. I could move it from, let's say, a Charles Schwab Roth IRA to a Directed IRA Roth IRA or a Fidelity Roth IRA. You can change the custodian. It just must stay a Roth IRA. And just a note here, there used to be a strategy where people would roll their Roth 401 dollars out to Roth IRAs once they hit retirement age of say 73. Because Roth 401s used to be subject to RMD. That changed as of recent retirement legislation 2 years ago. So as of now, Roth IRAs and Roth 401s are not subject to RMD. So there's no reason to do that rollover from a Roth 401 to a Roth IRA just to avoid RMD. You might want to do it anyways to give greater investment options, but you don't need to do it to avoid the RMD. Now, many people who have a Roth 401 also have a Roth IRA, and you may be using the Roth 401 at your employer. You're getting a match, you're maxing out contributions of $10,000 or $20,000 plus that you can't do in a Roth IRA. So we're building up the Roth 401, and as you leave that employer, you likely will roll it out to a Roth IRA, or when you retire, it'll likely roll again to a Roth IRA. And so you might end up with the Roth IRA, But you started and built those dollars as a Roth 401, that's fine. You're still going to get that tax-free growth and tax-free treatment. And Roth 401 can go to Roth IRA. Just remember, you can't go Roth IRA into Roth 401. So whether you're using a Roth IRA or Roth 401 is about the order of operations during your earning years. As I'm contributing money, how much? Am I getting a match? Am I maxing them out? Am I high income? But this isn't a forever choice. You might roll it all out to a Roth IRA anyways. One quick planning tip here though, if you don't have a Roth IRA yet and you're getting close to retirement, open one up now, even with a small contribution, because this starts your lifetime clock today for Roth IRAs, because you must have a Roth IRA for 5 years before you can pull it out tax or penalty-free. But that clock of 5 years starts on the first Roth IRA you establish. after making your first contribution. And that means you can eventually roll your entire Roth 401 dollars over to the Roth IRA and immediately start taking distributions. If you didn't do that, you will otherwise have another 5 years you're waiting to get money out of the Roth IRA. And what I see with many clients is at the end of the day, even though they may have used a Roth IRA and a Roth 401 during their earning years, at retirement, as they're in their 60s, 70s, and on, They're having a Roth IRA. So using the Roth 401 and the Roth IRA as you're earning and contributing, it's just a question of how much money is flowing through the 401 because of the contributions, the additional amount you can put in over $7,500, and the match you might get. We're building that up, but eventually it's likely to roll out and end up in a Roth IRA. When you're thinking about whether you should be using a Roth IRA or a Roth 401, You're actually likely going to use both. Maybe you're using one or the other at certain times in your life. Maybe there's a period where you're using both, but in the end, you end up with the Roth IRA in retirement. But I wanna go through how you should be thinking about this as you're contributing and growing and building wealth. Step 1, what should I be using first? Well, if you have a 401 at work, you should be doing a Roth 401. Make your contribution there. But only up into the amount you need to to get the full employer match. Go get your match. You're going to double your money. Most companies do a dollar-for-dollar match. Again, in the example we gave, making $100,000 a year, you put in $4,000, the company matches $4,000, you've got $8,000 in your 401, 100% return. After that though, we are going to go over to a Roth IRA to put your next $7,500. Why would I jump over to a Roth IRA and set up a whole nother account? Well, I have more control. I have greater investment options. I could pick individual stocks or other index funds, lower fee products. I could self-direct it and do a Roth IRA investing in real estate or private companies or startups. You have greater flexibility and control with a Roth IRA, and that's where the next $7,500 goes. I'm not getting a match anywhere at my employer anymore. So I'm going to the Roth IRA next. Step 3, we're gonna go back to the Roth 401, and we're gonna take up the remaining of the $24,500 that I have left after I already put the initial amount in, in step 1 to get the full match. Now again, if you're at step 3 here, we're talking about someone trying to put $30,000, $40,000 plus into their 401 each year of Roth dollars, including some into a Roth IRA. Roth IRA. So you might have stopped at step 2. You weren't trying to get this much in or didn't have a budget for this much, but I just want to keep going here so you can see you can be getting $30,000+ of Roth dollars a year between your company 401 and a Roth IRA. And I just want to note here, if you're a high-income earner, you may have needed to do the backdoor Roth IRA to take advantage of the $7,500 in a Roth IRA. If you have a spouse, You could be doing $7,500 a year in your spouse's Roth IRA. Again, might need to be backdoor if you're high income. If you're 50+, there's additional catch-up contributions you could be putting in as well. So we can be putting $30,000, $40,000, $50,000 a year of Roth contributions in using these strategies. And I like going in that 1-2-3 order. Get the match, get out, go to the Roth IRA, greater investment flexibility. Go back to the Roth 401 later to fill up the rest of the $24,500 contribution bucket everyone has available. Just one quick example here to show the whole framework. Let's say you can save $15,000 a year at a job that offers a 4% match and you're making $100,000 a year. Well, we're gonna put $4,000 into the Roth 401 and we're gonna pick up the match. We're gonna drop the next $7,500 into the Roth IRA, and then the remaining $3,500 is gonna go back into the Roth 401. That's where those $15,000 are gonna be broken up. I got the match, I put money in a Roth IRA, and then I went back into the Roth 401. Every dollar is placed where it is working the hardest. We work so hard earning and making money, we should have our investment dollars working as hard for us. And one other aside here, if you're someone who's self-employed, you can do something called a solo 401. In this whole video, I've assumed you have a 401 at somewhere that is your job, where you have an employer, they're throwing money in on the match. But if you're self-employed, you can have your own Roth solo 401, where you can be putting up to $72,000 a year of Roth dollars into your own Roth solo 401. It's even better than what we've been talking about here. But just as we're thinking about Roth IRAs and Roth 401s in general and how to get those funded in the funding order we just talked about, Make sure you're following that. Too many people lose money because they don't realize this was a sequence of how you get the dollars in. They think of the Roth IRA versus Roth 401 as a rivalry and they choose a side. I don't want you doing that. Think of where your money's going to work the best, how it's going to grow, and the benefits of the different accounts for your situation. So here's the bottom line. The Roth IRA and the Roth 401, they're not competitors. They're teammates with different jobs, both working for you. One of them brings a bigger contribution amount and free money with the match. The other is bringing freedom, freedom to access the money early, more freedom in how you can invest it and how you can consolidate these accounts on your terms. The people who are building the biggest tax-free buckets aren't the ones who picked the right account. They're the ones who used both. In the right order. So tell me in the comments, which camp have you been in? Roth IRA only, Roth 401 only, or are you doing both? And did anything change your funding order that we talked about today or how you view those accounts? I do read the comments and they turn into future videos, so please do share. And if the investment control side of this got your attention, putting your Roth IRA into real estate, private funds, the assets you actually know, That's exactly what we do at my company, Directed IRA. We set up Roth IRAs and Roth 401s every day, and we'd love to set you up with the tools you need to build the retirement you are looking forward to. Book a free 15-minute call. The link is in the description right underneath the free guide. Thank you everyone for listening to this special episode of the Directed IRA Podcast. I hope you learned something that you didn't know already about Roth IRAs and Roth 401s' powerful tax-free wealth-building machines, but lots of differences that you can use to your advantage. Please share this with your friends and family. We'll see you next week on the Direct to IRA podcast.