- A Roth 401(k) allows you to make taxable contributions today—and get tax-free retirement income later.
- Roth 401(k)s can be good if you think you may be in a higher tax bracket in retirement—or if your income level makes you ineligible for contributing to a Roth IRA.
- Like other types of tax-advantaged retirement vehicles, Roth 401(k)s come with contribution limits and rules around withdrawals to avoid penalties.
Retirement is one of the most important financial goals to plan for. And you’ll want to ensure that you can take a long and well-deserved break after a lifetime of work.
But the process of getting there can be work in itself: Tax-advantaged retirement vehicles, like IRAs, 403(b)s and 401(k)s, can quickly sound like alphabet soup.
It starts with knowing all your options. And one option many Americans have—but don’t know enough about—is the Roth 401(k). Sponsored by your employer and offering a unique way to glean tax-free retirement income, it could be an important financial tool in your retirement plan.
Here’s what you need to know about the Roth 401(k) to decide if you should open one if your employer offers it.
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The lowdown on the Roth 401(k)
If you have a job where you earn hourly wages or a salary—income reported on a W-2 form—chances are good that your employer offers a suite of benefits, including retirement options. One of the most common forms of employer-sponsored retirement plans is the 401(k).
A 401(k) is a retirement plan that allows you to save for retirement by automatically having a portion of your paycheck go into the account (this income is “deferred”). Your contributions may be partially matched by your employer, and both your personal and total contributions are subject to limits set by the Internal Revenue Service (IRS).
Most 401(k)s are traditional—which is to say, the money you contribute to the account is deducted from your income taxes the year you contribute, but the withdrawals you take later in retirement are subject to regular income tax.
But there’s also such a thing as a Roth 401(k), which is the same kind of account, but with the tax structure flipped on its head. Instead of having your contributions deducted from your income taxes now, they’ll be subject to taxation but you’ll be able to withdraw both contributions and earnings tax-free come retirement.
Like other types of tax-advantaged retirement plans, additional limitations and regulations apply. For instance, with very few exceptions, you can’t take an untaxed withdrawal from your Roth 401(k) until you reach age 59½ and until five years have elapsed since your first contribution to the account. Withdrawals made outside of these parameters will result in the funds being taxed a second time—as well as a 10% early withdrawal penalty tacked on if you take the money out before reaching the designated retirement age.
Roth 401(k)s are still subject to RMDs, or required minimum distributions—which means you’ll be obligated to begin taking withdrawals once you reach a certain age designated by the IRS (currently 70 or 70½, depending on when you were born).
Weighing the pros and cons of a Roth 401(k)
The benefits of a Roth retirement account are obvious—tax-free income at retirement—which sounds pretty good to most of us.
Still, this type of account isn’t right for everyone. Malik S. Lee, Certified Financial Planner and founder of Felton & Peel Wealth Management, says that it’s not a “one-size-fits-all” scenario when it comes to deciding whether to contribute to a Roth or a traditional 401(k).
“If you’re in a high tax bracket or writing big checks to Uncle Sam every year,” says Lee, “then the tax breaks of a traditional 401(k) might be better right now. In contrast, forgoing pre-tax contributions and saving to a Roth 401(k) might be a better option if you find yourself in a low tax bracket or always receive a refund check.”
Basically, the idea is this: Whether you choose a traditional or Roth 401(k) account, you’re going to pay income taxes on the money. The question is simply when.
The thinking is, if you’re in a higher tax bracket now than you plan to be in retirement, a traditional account makes more sense. Although you’ll still pay income tax when you withdraw from the account, it’ll be at a lower rate than it would be today.
On the other hand, if you’re going to be in a higher tax bracket come retirement time, tax-free withdrawals could be a major boon to your overall financial stability, even if it means taking the tax hit now.
Of course, any sort of retirement savings plan involves some unknowns because no one can tell what the future will look like. Still, saving now is a much better course of action than not saving anything at all.
Roth 401(k) vs. Roth IRA
Those who will probably be at a higher tax bracket at retirement aren’t the only folks who could benefit from a Roth 401(k), says Lee. He also recommends them to earners who are above Roth IRA income limits.
As a quick refresher, a Roth IRA is another type of retirement account, but it’s not sponsored by an employer; you can open one even if you’re self-employed. It has the same kind of pay-now-save-later tax structure, but other rules are different. Here’s a look:
Roth IRAs have income limits that disqualify those who make too much from contributing. In 2022, those limits are $144,000 for single filers or $214,000 for married couples filing jointly.
Roth 401(k)s, on the other hand, do not have these income limits, which gives higher earners access to Roth benefits.
Both Roth IRAs and Roth 401(k)s come with contribution limits—a cap on how much you can put in the account each year. However, the Roth IRA limits are substantially lower—$6,000 in contributions per year (or $7,000, if you’re age 50 or over) in 2022. Compare that to the much higher Roth 401(k) limits: $20,500 (or $27,000 if you’re age 50 or over). That gives you a whole lot of additional retirement savings potential.
Once you’ve made the decision to contribute to a Roth 401(k), you still have more decisions to make: namely, how to allocate, or invest, the assets in the account. Given the number of stocks and bonds to choose from, this task could be daunting—but it doesn’t have to be.
Andrew Lokenauth, a longtime finance executive and personal finance expert, says that for most people, a major index like the S&P 500 is a choice that’s both simple and reliable (or as reliable as the stock market can ever be).
“It’s an easy and stress-free way to invest for the majority of people, because you’re not betting on a single company but 500 of America’s largest companies instead,” he says. You can invest your money in an index fund that tracks the S&P 500.
Whatever you decide, keep in mind that diversification is key, which is why opting for an index fund or mutual fund can be a smart move: Both are made up of many different individual stocks and bonds.
Of course, the specifics of what assets you’ll be offered vary depending on your 401(k) plan. Check with your company’s HR representative for full details. Also, if you leave your company, you may want to consider rolling over your Roth 401(k) into a Roth IRA, which gives you more investment choices.
No matter what your retirement savings vehicle is, the most important thing is to start saving as soon as possible. When it comes to earning interest, time works in your favor, so the earlier you get started, the better … but it’s also never too late to start.