A Roth 401(k) is an employer-sponsored retirement plan that allows for after-tax contributions. It combines the features of a Roth IRA and a traditional 401(k) to allow for tax-free distributions in retirement.
Although many people haven't heard of Roth 401(k) plans, they are becoming increasingly common among employer-offered retirement plans. But, if your employer offers you the option, how do you choose? It's important to understand how taxes will work in a Roth 401(k) vs. a traditional 401(k) before you make your decision.
What Is a Roth 401(k)?
Roth 401(k) plans are only available through employers that choose to offer them. If you elect to take advantage of the plan, any contributions that you make are after-tax investments. You will not get a tax break or lower your taxable income when you choose to invest in a Roth 401(k).
As with a 401(k), employers can choose to match any contributions you make through the plan. Unlike your contributions, matching employer contributions are made pre-tax into a separate account. This means that when you take Roth 401(k) distributions in retirement, they will be partially taxed.
- Distributions from your own contributions will be tax-exempt.
- Distributions from employer contributions will be taxed.
There can be definite tax advantages to a Roth 401(k), but the biggest pro is that once you are retired, you can withdraw your funds tax-free.
- Alternate name: Designated Roth account
There can be definite tax advantages to a Roth 401(k), but the biggest pro is that once you are retired, you can withdraw your funds from your own contributions tax-free.
How a Roth 401(k) Works
If your employer chooses to offer a Roth 401(k) option, you'll be able to select how much you want to contribute each pay period from your after-tax income. These contributions will go into an account and grow tax-free. Any matching contributions your employer makes will go into a separate, standard 401(k) account and grow tax-deferred until you take distributions.
The annual contribution limits for a Roth 401(k) are the same as they are for a traditional 401(k): $19,500 in 2020 and 2021 ($26,000 for employees 50 and over). This is much higher than a Roth IRA, which maxes out at $6,000 ($7,000 for employees 50 and over).
Withdrawals from the employee-contributed account are tax-free as long as you have been contributing to the plan for at least five years and one of the following is true:
- You are at least 59.5 years old.
- You become disabled.
- Beneficiaries take distributions upon your death.
As with a traditional 401(k), you must begin taking minimum distributions from your Roth 401(k) by age 72 (age 70.5 if you reached age 70.5 before Jan. 1, 2020) unless you are still working and don't own 5% or more of the business.
Roth 401(k) vs. Traditional 401(k)
A Roth 401(k) is similar to a traditional 401(k) in many respects, with one main difference—it deducts your contributions (but not employer contributions) post-tax. That way, you will likely not have to pay taxes on your distributions and income when you retire.
When considering either a traditional 401(k) or a Roth 401(k), do your research to figure out the best option for you.
First, estimate the tax bracket in which you will be during retirement, as this will affect the amount of tax you may have to pay. If you expect to be in a higher tax bracket when you retire, a Roth 401(k) may make more sense. However, if you estimate that you will be in a lower tax bracket when you retire, then contributing to a traditional 401(k) makes more sense.
If you're unsure about your future tax bracket compared to your current one, you can always split your contributions between a designated Roth 401(k) and a traditional 401(k).
How Much Should I Contribute to Retirement?
Experts suggest putting aside 15% of your take-home pay for retirement, but you may need to work up to this amount. That's OK; the important thing is to get started.
You may also want to open a Roth IRA and contribute to both that and your 401(k) to max out your retirement savings. If you do this, choose an IRA that allows you to invest in mutual funds as opposed to one that just offers CDs, like the ones you may find through your bank. Mutual funds will give you a higher rate of return and help you build your retirement savings more quickly.
What Happens if I Change Jobs?
If you change jobs, you can roll your 401(k) into another 401(k) or an IRA. When you do this, you should roll it into the same type of account. For example, if you have a Roth 401(k), you can roll it into a Roth 401(k) or a Roth IRA; you can't convert distributions from a Roth 401(k) to a traditional 401(k) or IRA.
You can roll a traditional 401(k) into a Roth 401(k) or IRA, but you will be expected to pay taxes at the time of rollover. If you do not have the money available, it is best to roll it into a traditional account instead.
These rollover rules can get complicated, so consider talking to your CPA or financial planner and decide how a Roth 401(k) could benefit you and the right way to do any rollover. Your financial planner can also help you to develop an overall investment strategy that will help you build wealth over time.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
- A Roth 401(k) is an employer-sponsored retirement plan that allows for after-tax employee contributions and tax-free withdrawals in retirement.
- Any employer contributions to the plan are made pre-tax and kept in a separate account, which is taxed on withdrawal in retirement.
- If you expect to be in a higher tax bracket when you retire, then a Roth 401(k) might be a good option for you.