Roth 401(k) vs Roth IRA: Where Should You Put Your After-tax Dollars?

In an effort to provide their employees the right tools to optimize their retirement savings, more and more U.S. employers are offering 401(k) plans that accept after-tax contributions (Roth contributions). In 2016, 65% of Vanguard plans offered Roth contributions, up from 49% in 2012, according to Vanguard’s How America Saves 2017 report. Despite the increase in workplace plans offering this feature, there has been little change on the percentage of employees making after-tax contributions. During the same period, the percentage of participants using Roth went from 10% to 13%.

If you’re considering making after-tax contributions to a retirement savings account, you also may have the option to save using a Roth IRA. Let’s review key criteria to help you determine what retirement account would make sense for you.

Roth 401(k) vs. Roth IRA criterion #1: What’s your income?

Your current or future paychecks can quickly determine your available options to save with after-tax dollars for three reasons.

Once you reach a certain income threshold, you’ll no longer be eligible to enroll in a Roth IRA

In 2017, here are the income limits to be eligible for a Roth IRA:

High-income workers may not be able to contribute as much to a Roth IRA

In 2017, you can contribute up to $5,500 ($6,500 if age 50 or over) to a Roth IRA. But there’s a catch for high earners. While they may still qualify for a Roth IRA, those retirement savers may contribute up to a lower amount.

Again, your MAGI determines up to how much you can contribute to a Roth IRA. Here are the Roth IRA contribution limits for 2017:

*To figure out your reduced contribution limit, refer to worksheet on  Publication 590-A, Contributions to IRAs.

Individuals aged 50 and over are eligible to make an extra $1,000 in catchup contributions to a Roth IRA.

Low- to moderate-income workers can qualify for the Saver’s Credit with their Roth IRA contributions

Workers who are age 18 or older, not studying full-time for any 5-month period of the year, and not claimed as dependents on somebody else’s return may qualify for the Saver’s Credit, a tax credit that reduces the amount of taxes owed to the IRS by up to $1,000 ($2,000 for joint filers).

Here’s how much you claim as Saver’s Credit  in 2021:

If your adjusted gross income (AGI) meets these thresholds, contributing with after-tax dollars to a Roth IRA rather than a Roth 401(k) would make sense. After-tax contributions to a Roth IRA qualify for the Saver’s Credits, while those to a Roth 401(k) don’t.

In summary, your income levels can help you choose between a Roth IRA or Roth 401(k).

Criterion #2: What fees would you be paying in the Roth IRA vs.the Roth 401(k)?

From the list of scenarios above, investment charges are a key determinant of whether you would contribute to both a Roth 401(k) and a Roth IRA, or just one of the two. While the idea of contributing up to $5,500 ($6,500 if age 50 or over) to a Roth IRA and up to $18,000 ($24,000 if age and over) to a Roth 401(k) sounds very logical, you need to take into consideration what are the applicable fees of those plans. (Note: In 2018, the Roth 401(k) numbers will increase to $18,500 and $24,500, respectively!)

Any retirement plan with excessive fees and highly variable returns could dramatically reduce (or even wipe out!) your nest egg. A November 2014 report from the U.S. Government Accountability Office (GAO) found that some IRA plans have administrative fees, ranging from $0 to $100 or more to open the account, and $0 to $115 per year to retain the account. The same report found that a mix of high fees and low returns can make IRA plans with low balances decrease to $0 within a period of 30 years.

Paying too much in fees (especially across too many different kinds of fees and accounts) is why having multiple retirement plans is a bad idea.

So, what is a red flag that a plan charges high fees? Simple: the lack of access to low-cost index funds.

One of the top characteristics of the best 401(k) plans is the offer an index “core” of low-cost passively-managed funds covering U.S. equities, non-U.S. equities, U.S. taxable funds, and cash. In 2016, 57% of Vanguard plans offered an index core covering at least these four options, up from 33% in 2007. A great Roth 401(k) or Roth IRA plan should give you access to index funds because they have lower expense ratios than those from actively-managed funds and tend to outperform actively-managed funds.

The national average expense ratio of all funds for 401(k) plans is 0.39%, meaning that you would pay $39 in fees for every $10,000 in your account. While that may not seem like much, with index funds, you can do much better. For example, Human Interest provides access to low-cost index funds, including the Admiral share class of Vanguard index funds, which have a low annual expense ratio. In fact, average fund expense ratios in Human Interest’s core fund lineup are just 0.07%¹, five times less than the national average mentioned above.

In summary, when comparing a Roth 401(k) to a Roth IRA, check for access to low-cost index funds, compare annual expense ratios, and review the full schedule of fees. By chasing low costs, you maximize returns. A study conducted by Morningstar concluded that the annual cost of a fund is the only dependable predictor of future performance, even more so than Morningstar’s own popular star rating system.

More about how to find and identify 401(k) fees here: Hidden 401(k) Fees

Criterion #3: Does your employer even offer a Roth 401(k)? They may also offer a Roth IRA

Your company’s Roth 401(k)

If you do have a 401(k) plan, chances are it definitely offers a traditional (pre-tax) option, but make sure to ask if there is a Roth option as well, since it’s much less common. Keep in mind that even if you put your contributions into a post-tax Roth 401(k), any employer match contributions will still be held in the traditional 401(k).

Your company’s Roth IRA (in certain states)

When looking to save for retirement, unfortunately, some workers don’t have access to workplace retirement accounts at all (Roth or otherwise). Here is a breakdown of the stats:

• California: 7.5 million workers

• Connecticut: nearly 600,000 workers

• Illinois: 1.2 million workers

• Oregon: as many as 1 million workers

In an effort to boost retirement savings for all Americans, several state governments are working on requiring business owners without workplace retirement plans to enroll employees in state-sponsored retirement plans. The majority of these plans, such as OregonSaves and Illinois Secure Choice, make a Roth IRA the default investment account for employees.

The EBRI’s 2017 Retirement Confidence Survey showed that approximately two-thirds of non-saving workers say they would be likely to save for retirement if automatic paycheck deductions with the option of changing or stopping them, at either 3% or 6% of salary, were used by their employer. This is exactly what a state-sponsored retirement plan does.

In summary, workers without access to an employer-sponsored 401(k) and those with access to 401(k) plan not offering Roth contributions (about 35% of all Vanguard plans in 2016), having access to a Roth IRA through a state-sponsored plan provides the option to save for retirement with after-tax dollars.

Here is list of in-depth reviews of a few state-sponsored retirement plans:

• Retirement Plan Laws in California: California Secure Choice 2017

• Retirement Plan Laws: The Connecticut Retirement Security Program (CRSP) for Small Businesses

• Illinois Secure Choice 2017 and 2018: Retirement Savings Plan Requirements and Deadlines

• Retirement Plan Laws in Oregon: The Basics of OregonSaves 2017

The bottom line

Saving with after-tax dollars is possible for most workers. Choosing to contribute to both types of Roth accounts or to just one depends on how much you can afford to withhold from your paycheck. Remember that unlike deferred contributions, after-tax contributions receive an upfront tax hit. Use your level of income, schedule of fees from plans that you’re eligible for, and access to a state-sponsored retirement plan to choose between these two types of Roth accounts.