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TCP CPA Practice Questions Explained: Roth IRAs and 401(k)s

Roth IRAs and 401(k)s

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In this video, we walk through 5 TCP practice teaching about Roth IRAs and 401(k)s. These questions are from TCP content area 1 on the AICPA CPA exam blueprints: Tax Compliance and Planning for Individuals and Personal Financial Planning.

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Roth IRAs and 401(k)s

Roth IRAs

How Roth IRAs Work: Roth IRAs are individual retirement accounts that offer tax-free growth and tax-free withdrawals in retirement. Contributions to Roth IRAs are made with after-tax dollars, meaning they are not deductible on your tax return. Because taxes are paid on the front end, all withdrawals made during retirement (after age 59½ and once the account has been open for at least five years) are completely tax-free. This includes both the initial contributions and any earnings accrued.

Example of Contributions and Earnings:

  • Contributions: If Alice contributes $5,000 annually to her Roth IRA for 10 years, she invests a total of $50,000 of after-tax money.
  • Earnings: If her investments grow at an average rate of 7% per year, her account may grow to about $71,000 after 10 years, where $21,000 represents earnings on her contributions.

Early Withdrawals: Withdrawals from a Roth IRA are taken in a specific order: contributions are withdrawn first, then conversion and rollover amounts, and lastly, earnings. Contributions can be withdrawn at any time without taxes or penalties. However, early withdrawals on earnings may incur a 10% penalty unless they qualify for an exemption like educational expenses, a first-time home purchase (up to $10,000), or unreimbursed medical expenses.

Example of Early Withdrawal:

  • If Alice withdraws $10,000 from her Roth IRA, and she has previously contributed $50,000, the entire withdrawal is classified under contributions and is thus penalty- and tax-free.

401(k)s

How 401(k)s Work: A 401(k) is an employer-sponsored retirement plan that allows employees to save and invest a portion of their paycheck before taxes are taken out. Contributions reduce their taxable income, and the funds grow tax-deferred until withdrawn in retirement. Some employers offer a Roth 401(k) option, where contributions are made with after-tax dollars and withdrawals are tax-free, similar to a Roth IRA.

Employer Matching: Many employers offer a match on contributions, which is essentially free money. For example, an employer may match 50% of employee contributions up to 6% of their salary.

Example of 401(k) Contributions:

  • Contributions: Bob contributes 10% of his $60,000 salary ($6,000) annually to his traditional 401(k).
  • Employer Match: His employer offers a 50% match up to 6% of his salary, contributing an additional $1,800 to Bob’s 401(k).

Early Withdrawals: Withdrawing funds from a 401(k) before age 59½ generally results in a 10% penalty in addition to being taxed as ordinary income. Exceptions include hardship withdrawals, such as certain medical expenses, which may still be subject to taxes.

Example of Early Withdrawal:

  • If Bob withdraws $10,000 from his traditional 401(k) for a non-qualified expense, he faces a 10% penalty ($1,000) and the withdrawal is taxed at his income rate.

Differences Between Roth IRAs and 401(k)s

  1. Tax Treatment: Roth IRAs use after-tax dollars for contributions and provide tax-free growth, while traditional 401(k)s use pre-tax dollars and defer taxes until withdrawal.
  2. Withdrawal Rules: Roth IRAs do not require RMDs (Required Minimum Distributions) during the owner’s lifetime, whereas 401(k)s do require RMDs starting at age 72.
  3. Contribution Limits: Roth IRA contribution limits are generally lower than those for 401(k)s. For example, in 2023 the limit for Roth IRAs was $6,500 ($7,500 for those 50 or older), while for 401(k)s it was $22,500 ($30,000 for those 50 or older).
  4. Employer Contributions: 401(k) plans may include employer contributions, but Roth IRAs are solely funded by the individual.

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