The Most Confused Investment Topic, by a Mile

Back in April, I wrote a blog titled “Ain’t no Dollar like a Roth Dollar,” addressing the importance of funding Roth 401(k) or Roth IRA accounts instead of Pretax 401(k) or Pretax (Traditional) IRA. I want to further the conversation about the core differences between 401(k) and your own individual IRA because it is by far the single most commonly confused investment topic.

Just to visually map them both out:

With your employer’s 401(k) plan (to include Non-Profit 403(b) or Federal Government Thrift Savings Plan), you may elect either Pretax or Roth contributions.

With your own IRA, you may elect either Pretax or Roth contributions, assuming you meet certain criteria.

Here is the Bottom Line Up Front (BLUF, to the Marines out there): Your company 401(k) plan and your own IRA are two entirely separate accounts that merely share some tax characterizations. The rules are different, the contribution limits are different, and the income limits are different.

I’ll cover some of the key distinctions between a 401(k) and your own individual IRA, then I will give an example of the questions I often receive from folks when discussing the topic.

First, a handy-dandy table to break out the differences between retirement plans.

401(k) vs. IRA: A Side-by-Side Comparison

1. All-Source Contribution limits, aka 415c limits, are a total of your Pretax 401(k) or Roth 401(k) contributions, company Non-Elective Contributions, Company Matching, and Additional After-Tax Contributions.
2. You fund a 401(k) directly from your paycheck by setting withholding elections on your plan provider’s website. For an IRA, you fund the account with your own cash. If you fund a Pretax IRA and don’t exceed the income limitation, then you may be eligible for an income tax deduction after-the-fact while filing your taxes.
3. 401(k) plans must be funded by the end of the calendar year. IRAs may be funded until your tax filing deadline, which is generally April 15^th of the following year, plus extensions. The IRS gives you time after the end of the year to figure out your overall adjusted gross income to determine if you qualify for an IRA contribution or deduction.
4. Your 401(k) contributions may be limited if your company notifies you that you are a “Highly Compensated Employee” and are thus limited on or entirely restricted from 401(k) contributions. This is commonly for “top-heavy” retirement plans where too many higher income folks are enjoying benefits of the plan relative to the lower income employees. If you haven’t been notified by your company, then nothing to worry about here. If you have, then you may have an alternative Deferred Compensation Plan that mimics a 401(k) in many ways but is technically a Defined Benefit Plan with a separate set of risks and considerations that are outside the scope of this blog.

Now onto some common questions and confusion:

“I didn’t think I could contribute to a Roth IRA, because I already do Roth at work.”

Remember, one doesn’t have anything to do with the other. You can do Roth 401(k) contributions at work, then if you are eligible, you may either do direct Roth IRA contributions, or if you earn over the Roth IRA income limits, you may be eligible for a Back-Door Roth IRA conversion.

“I thought I made too much money to do Roth 401(k) at work.”

No, those income limitations are on your own Roth IRA, not your Roth 401(k).

“I thought I could only do $7,000 in my Roth 401(k) at work.”

No, that’s the limit for your personal Roth IRA. The limit this year for your 401(k) is $23,500, plus Catch-Up if 50+.

“Since the Roth 401(k) is after-tax, isn’t there a lower tax-adjusted contribution limit?”

No, and this is something I addressed in my previous Roth blog. The limit to either Pretax 401(k) or Roth 401(k) (or a combination thereof) is $23,500. So, if you think about it, the $23,500 in Roth 401(k) contributions is effectively more money to you because none of the contributions or the subsequent growth is owed in taxes upon distribution.

“My spouse is not employed, so he/she doesn’t have an IRA.”

Unemployed spouses don’t have access to their own 401(k), but as long as either of you have earned income, both of you may be eligible to contribute to your own IRA or Roth IRA. This is one of the most overlooked opportunities I see.

“Since I started at my new company, I haven’t elected to contribute to my 401(k), so I’m not doing that right now.”

You probably are contributing even if you don’t know it. Once you become eligible, most companies automatically enroll you in 2-3% Pretax Contributions into a Target Date Fund based on your age. You should probably register on your company’s 401(k) plan website and make appropriate changes.

“I think my 401(k) automatically enrolled me in Roth 401(k) contributions.”

The default enrollments in company 401(k) plans are always Pretax contributions and are generally allocated to a Target Date Fund based on your age. Further, the contributions are generally only 2-3%. You need to log in to your company 401(k) website and increase contributions, and switch to Roth 401(k) and Roth Catch-Up if 50+. “You gotta pump those numbers up! Those are rookie numbers!” I’m pretty sure that’s what Matthew McConaughey’s character was talking about in The Wolf of Wall Street.

“Can I do Roth with my Matching Dollars at work?”

Matching Dollars in a retirement plan are currently only Pretax, even if you are doing Roth 401(k) contributions. They will be broken out separately on your statement. Allegedly, there is a provision in Secure Act 2.0 that allows you to elect to have Matching Dollars taxed and contributed to Roth 401(k) balance so that they grow tax free into the future. However, I haven’t seen this implemented in any retirement plans yet, likely due to lack of instructions or details from the IRS. Your only other option, until this is implemented, is to request a conversion of pretax Matching Dollars to your Roth 401(k), assuming the plan allows these requests. If so, the Pretax balance will be taxed at Income Tax rates when it converts.

“OMG Brent you know so much!”

I’m blushing but thank you. It’s our job and our passion, so never hesitate to reach out with questions. And certainly, don’t keep us a secret from your friends or family that may have these types of questions! We are always happy to chat!

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Brent Elyea and not necessarily those of Raymond James.

Every investor's situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation.

Changes in tax laws or regulations may occur at any time and could substantially impact your situation. While familiar with the tax provisions of the issues presented herein, Raymond James Financial Advisors are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional.