What's a Roth IRA? How to pick the best retirement account

June 6, 2021

Dear Liz: Can you explain the difference between a Roth IRA and a Roth 401(k)? What are the benefits of a Roth 401(k)? My company offers it and I am considering beginning to make deferral contributions there while continuing my 401(k) contributions.

Answer: Contributions to Roth IRAs and Roth 401(k)s are after tax, which means you don’t get an upfront tax deduction as you do with traditional IRA and 401(k) accounts. But the money grows tax deferred and can be tax free in retirement.

You typically open and contribute to a Roth IRA at a brokerage, which gives you access to a wide range of investment options. Just like traditional 401(k) accounts, Roth 401(k)s are offered by an employer, usually with a limited number of investment choices.

Roth 401(k)s allow people to contribute significantly more than they could to Roth or traditional IRAs. Roth 401(k)s also allow contributions by higher earners, who might be shut out of contributing to a Roth IRA.

Roth IRA contributions are limited to $6,000 with a $1,000 catch-up contribution for people ages 50 and older. Your ability to contribute begins to phase out at certain income limits. This year, the phase outs start at $125,000 of modified adjusted gross income for single filers and $198,000 for married couples filing jointly.

Roth 401(k)s don’t have income limits and allow you to contribute as much as $19,500 ($26,000 for those age 50+). That is the combined limit for elective deferrals from your paycheck. If you’re under 50 and contributing $10,000 to the pretax portion of the 401(k), for example, you could contribute a maximum of $9,500 to the Roth option.

Roth IRAs and Roth 401(k)s also have different rules for withdrawals. You can remove your contributions from a Roth IRA at any time without paying taxes or penalties. Withdrawals from a Roth 401(k) before age 59½ also can incur taxes and penalties, although you usually do have the option to take loans.

Also, you’re not required to start taking withdrawals at age 72 from a Roth IRA, as you typically are with other retirement accounts, including Roth 401(k)s. You will have the option of rolling a Roth 401(k) into a Roth IRA, typically after you leave your job, so you can avoid minimum required distributions that way.

A sudden death brings dilemma

Dear Liz: My son suddenly passed away and his $1-million life insurance policy was awarded to me, his mother. I want the money to be divided equally between his two children for future use. They are 18 and 15 now. What financial vehicle should I use? The funds are in my money market account just waiting to be placed into something.

Answer: Please use some of the money to pay for individualized counsel from advisors who are fiduciaries. Fiduciary means the advisor is required to put your best interests first. Most advisors are not fiduciaries but you can find financial planners who are through the National Assn. of Personal Financial Advisors, the XY Planning Network, the Garrett Planning Network and the Alliance of Comprehensive Planners.

The vehicle or vehicles you use for the money will depend on your goals and how you want to distribute the funds over time. You’ll need good advice about how to invest, minimize taxes and incorporate the money into your own estate plan. Distributing money to your grandchildren can trigger the need to file gift tax returns, although you wouldn’t actually owe gift taxes until you’d given away millions of dollars.

Your son may have chosen you as his beneficiary because he trusted you to do right by his children. Or he may not have updated his beneficiaries since applying for the policy. (More than a few ex-spouses have wound up with life insurance proceeds because the policy owner didn’t update the beneficiaries after the divorce.) It’s a good idea to check the beneficiaries on any life insurance once a year or after any major life change to make sure the money is still going where you want.

Liz Weston, Certified Financial Planner, is a personal finance columnist for NerdWallet. Questions may be sent to her at 3940 Laurel Canyon, No. 238, Studio City, CA 91604, or by using the “Contact” form at asklizweston.com.