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A Roth 401(k) is one of the two major types of 401(k) plans, and it offers significant tax benefits for workers saving for retirement. The Roth 401(k) is an employer-sponsored plan, meaning that you can use the plan only if it’s offered at your workplace. The other major plan is the traditional 401(k), and it offers significant – but different – tax benefits for retirement saving.
Here’s what you need to know about the Roth 401(k) to decide if it’s the right choice for your retirement savings.
What is a Roth 401(k) and how does it work?
A Roth 401(k) is a tax-advantaged retirement plan offered through your employer. You contribute money to the account through withdrawals from your paycheck and then it’s put into investment funds consisting of stocks, bonds and other similar assets. While your money is in the Roth 401(k), it will enjoy special tax benefits, such as growing without being taxed.
The most notable benefit of the Roth 401(k) – and the one that experts love – is the ability to withdraw any money in the account tax-free at retirement age, which begins at age 59½. Employees make contributions to a Roth 401(k) with after-tax money, so they don’t receive a tax benefit on current taxes, like they do with a traditional 401(k).
Overview of the Roth 401(k)
A 401(k) plan offers numerous benefits, including the tax benefits noted above. These benefits include the following:
- Contributions are pulled directly from your paycheck, a feature that many workers like because they aren’t likely to miss the money.
- Tax-advantaged growth and withdrawal of your contributions, meaning your contributions can grow without paying any annual tax on your gains. Then when you withdraw the money in retirement, you won’t pay any taxes, either.
- Employers may match your contributions, adding to your pool of money, perhaps up to 5 percent of your salary. It’s like a risk-free return, though your plan may require a few years for the match to vest.
- Contributions of up to $22,500 for the year 2023, giving workers a lot of ability to save money for retirement. This number doesn’t include any employer match.
- Catch-up contributions of $7,500, for employees age 50 and older.
- The ability to take a loan against your funds, a feature that depends on your employer’s plan.
- Pre-selected investment funds, with the potential to receive some professional guidance on how to invest, depending on your employer’s plan.
- The plan is portable, allowing you to move it to a new employer’s plan, roll it over into an IRA or even keep it with your former employer.
But the Roth 401(k) offers some additional benefits:
- A Roth 401(k) can be rolled over without cost to a Roth IRA, which has no required minimum distributions (unlike a traditional 401(k) and traditional IRA).
- No income limits on eligibility, unlike a Roth IRA.
Bankrate’s 401(k) calculator can help you estimate your savings over time.
When can you access your Roth 401(k)?
If there’s one major drawback to 401(k) plans, whether Roth or traditional, it’s the inflexibility of the accounts. It’s tough to access any money in the account before retirement age without incurring an additional 10 percent tax penalty.
Withdrawals from a Roth 401(k) are tax-free if you meet two criteria:
- The account must be held for at least five years.
- The account holder reaches age 59 ½, or distributions are made in the event of death or disability.
Even if you do take money out earlier, you may not be slapped with the bonus tax on the full amount. That’s because with a Roth 401(k) your distribution consists of your contribution (which you’ve already paid tax on) and your earnings on the account (which have yet to be taxed). If you want to access your Roth 401(k) money without incurring a tax, you may have to take a loan against your account value, though it’s rarely a good idea to do so for many reasons.
However, in the event of severe hardship, your plan may allow a distribution. The rules around this distribution are strict, and the distribution must help meet an “immediate and heavy financial need.” Such needs could include medical costs, the purchase of a principal residence, college tuition for your immediate family, funeral expenses as well as a few other costs.
Your hardship withdrawals are limited to the amount of money that you personally have contributed to the account (so not including your employer’s match.) The hardship withdrawal also allows you to take out money to cover any taxes created by the withdrawal.
The Roth 401(k) plan stipulates that you must begin taking required minimum distributions from your account at age 73. However, you can avoid this requirement without penalty by rolling over your account to a Roth IRA, which offers significant tax and estate-planning benefits as well. And beginning in 2024, Roth 401(k) accounts will no longer be required to take minimum distributions, as part of the recently passed SECURE Act 2.0.
Don’t miss the employer match on the Roth 401(k)
One of the best benefits of a 401(k), whether a Roth or traditional plan, is the potential matching benefit offered by an employer. Whether you receive a benefit depends entirely on your employer. And the level of the match, if any, is up to your employer’s discretion, too.
Employers will typically offer a percentage match up to a maximum, say, 5 percent, of your total salary. For example, if you contribute 5 percent of your salary, your employer may kick in another 5 percent. You’ll end up with 10 percent of your salary in your Roth 401(k).
Sometimes the company may match portions of your contribution at different rates. For instance, your employer may match 100 percent for your first 3 percent and then 50 percent, until it contributes a total of 5 percent. So if you put in 5 percent, you’d get a match of 4 percent – 3 percent matched at 100 percent and 2 percent matched at 50 percent. If you contributed 7 percent, the company would put up an additional 5 percent.
Experts recommend that, at a minimum, employees contribute enough money to get the full match. As you can see, the match is an easy way to get quick returns on your money, and it’s risk-free money that you can’t afford not to take.
Note that an employer match may be contributed to a traditional 401(k) or a Roth 401(k). If your match goes into a traditional 401(k), you won’t owe tax on it immediately, only when the money is withdrawn. On the other hand, if your match goes into a Roth 401(k), you’ll owe tax on the match today but no further tax will be due when it’s withdrawn later.
Roth 401(k) vs. traditional 401(k)
The biggest differences between the Roth 401(k) and the traditional 401(k) concern taxes.
With a Roth 401(k), you contribute after-tax money to the account, so you’re paying taxes this year on your contributions. Your investments grow inside the account without incurring any tax liability. The big tax benefit comes at retirement when you’re able to take out your money – both contributions and earnings on them – completely tax-free.
With a traditional 401(k), you contribute pre-tax money to the account, so you’re avoiding taxes this year on your contributions. Then your investments grow inside the account without incurring any annual taxes. Later when you withdraw money from your account at retirement, any withdrawals are taxed as income.
Is a Roth 401(k) better than a 401(k)?
Whether the traditional 401(k) or the Roth 401(k) is better is a long debate. But many experts favor the Roth 401(k), because of its enviable ability to withdraw money in retirement tax-free. And you’ll be able to roll up any capital gains each year without paying any taxes.
A key difference with the traditional 401(k) is the tax benefit. In a traditional 401(k), you’ll avoid taxes on any income contributed to the account, but you pay taxes on withdrawals at retirement.
How do you balance these two advantages against each other?
The Roth is more beneficial if you’re paying relatively low tax rates now and expect to be paying higher rates in the future. In this situation, you can avoid high tax rates later when you withdraw money while paying lower rates today on money that goes into the account.
In contrast, if you think rates will be lower in the future – for example, if you expect your retirement income will be less than your current income – then it may make sense for you to use a traditional 401(k). You’ll avoid taxes at today’s higher rates and pay tax on withdrawals at tomorrow’s lower rates.
A Roth 401(k) may also be better when you already have money in a traditional 401(k) because it allows you to diversify and have access to both plan types. If you’re looking to choose between the two plans, you’ll want to have a closer look at the pros and cons of each.
Can I contribute to both a 401(k) and a Roth 401(k)?
You can contribute to a 401(k) and a Roth 401(k) over the course of a year, but at any point in time, your account must be set to one type or the other. And it’s important to remember that however you divide your contributions, you’re still limited to the total annual maximum.
For example, if you want to contribute to a Roth 401(k) in the first half of the year and to a traditional 401(k) in the second half of the year, you can adjust your account to categorize contributions as one or the other. You’ll need to contact your plan administrator, and many plans allow you to go to the website and make adjustments yourself at any time.
The 401(k) administrator tracks which money went into which account type, maintaining the tax records that are vital for later when you reach retirement age.
The Roth 401(k) offers great benefits for workers looking to put away money for their retirement, not least of which is the ability to withdraw money tax-free. It’s a solid choice for higher-income workers, too, because it allows them to enjoy the tax benefits of a Roth account, whereas their income often prohibits them from taking advantage of the Roth IRA, except via a backdoor Roth.