When we think about 401(k) plans, we generally imagine the traditional setup, where you designate an amount to be deducted from each paycheck, and that money goes into your retirement plan tax-free. Roth 401(k)s work a bit differently in that your contributions are funded with after-tax dollars. So you don't get an immediate tax break for participating in your employer's plan.
But despite that fact, a growing number of workers are opting to save for retirement in a Roth 401(k), as opposed to a traditional one. According to a recent study by Bank of America Merrill Lynch, Roth 401(k) contributions increased 25% last year, compared to just 16% for pre-tax contributions. And interestingly enough, younger workers are the ones embracing the Roth, with 56.5% of contributions coming from savers 40 and under.
If you're not sure which type of 401(k) is right for you, it pays to learn more about the benefits of saving in a Roth. Here are a few to consider:
1. Generous annual contribution limits
Though both traditional and Roth 401(k)s come with the same annual contribution limits, it's worth noting how substantial they are. If you're under 50, you can put up to $18,000 a year into either type of 401(k), while those 50 and over can contribute up to $24,000 annually. IRAs, by contrast, only allow a maximum contribution of $5,500 a year for workers under 50 and $6,500 for those 50 and over.
2. Tax-free growth
When you contribute to a traditional 401(k), your money gets to grow on a tax-deferred basis. This means that you won't pay taxes on your investment gains year after year, but rather you'll only be taxed on your eventual account value when you start withdrawing from it in retirement. With a Roth 401(k), however, the money you contribute gets to grow completely tax-free, which means that once you pay taxes on the sum you put into your account, your IRS obligation ends there.
3. Tax-free withdrawals in retirement
Perhaps the most significant benefit of the Roth 401(k) is the ability to take tax-free withdrawals in retirement. This eliminates much of the risk of saving in a traditional 401(k). For one thing, we don't know what tax rates are going to look like in the future, which means that if you put your money into a traditional 401(k), your future taxes on withdrawals could be higher than anticipated. Furthermore, when you're dealing with a traditional 401(k), you'll need to factor those taxes into your retirement budget. With a Roth 401(k), however, the money that winds up in your account is yours to use in retirement free and clear, which can eliminate a fair amount of financial stress.
4. Early withdrawals without penalty
Although it's generally not a good idea to tap a retirement plan early, if a true emergency arises and you need to get at that money before age 59 1/2, you'll face a 10% early withdrawal penalty for removing funds from a traditional 401(k)s. Roth 401(k)s, however, don't work that way. Because you've already paid taxes on your contributions, there's no penalty for accessing the principal portion of your account (not your earnings) at any time and for any reason. In this regard, Roth 401(k)s offer far more flexibility than their traditional counterparts.
5. No income limits
One final thing to note about Roth 401(k)s is that unlike Roth IRAs, they don't have income restrictions. If your employer offers a Roth 401(k), no matter whether you earn five figures our nine figures, you can contribute directly and enjoy the perks that Roth accounts have to offer. It pays to not only learn more about Roth 401(k)s, but start saving in one at an early age to maximize the benefits involved.
The Motley Fool has a disclosure policy.