Roth 401(k) accounts provide great tax benefits to retirees, but not everyone takes full advantage of these savings. These accounts combine attractive features of some of the higher-profile alternatives. Consider the following features and perks to get the most out of your retirement plan.
Roth tax benefits
Roth IRAs are popular because they eliminate taxes on returns in a retirement account. The embedded tax liability can get rather large as assets grow in other types of accounts. The Roth 401(k) doesn't get as much press as its IRA cousin, but it provides the exact same benefit.
Roth contributions are made after taxes. They won't offer any upfront tax benefit, but they are still a powerful vehicle for long-term accounts that deliver significant returns over the year. Qualifying distributions from a Roth 401(k) aren't subject to capital gains or income tax. In contrast, withdrawals from a traditional IRA or 401(k) are taxed as ordinary income. A regular brokerage account is subject to capital gains as positions are closed.
That tax treatment is ideal for young retirement savers who are focused on growth. The more an account grows over time, the more the embedded tax liability grows -- Roth accounts eliminate the liability, allowing retirees to retain all of the gains. This makes Roths an ideal account to fund early in your career, and it makes them an efficient place to hold growth stocks and other high-upside investments.
Roth 401(k) advantages over the Roth IRA
The above tax benefits are common to both the Roth IRA and the Roth 401(k). The 401(k) version offers additional tax savings due to more relaxed limitations and employer sponsorship.
First, not everyone can participate in a Roth IRA. You can't make contributions if you make more than $153,000 per year (or $228,000 as a joint filer). There's no such income limitation for the 401(k) version.
You can also contribute a lot more to the Roth 401(k) annually, with each individual able to save up to $20,500 per year in the employer-sponsored plan. Roth IRA contributions are capped at $6,500 per year, plus a $1,000 catch-up provision for people aged 50 or over. By roughly tripling the amount you can save each year, the Roth 401(k) substantially increases the potential tax savings relative to the IRA version.
Roth 401(k) accounts can increase your savings rate through employer contribution matches. Not every employer offers a match -- and some packages are more generous than others -- but there's no match whatsoever for an IRA.
Prior to 2022's SECURE 2.0 Act, those matching contributions had to be made with pre-tax dollars, as if they were part of a regular 401(k) plan. Employers now have the option to select the tax treatment of contributions, regardless of the employee's selection. This could result in tax deferrals on some of your 401(k) assets. That's good in the short term, but it leads to taxation on account distributions down the road.
The SECURE 2.0 Act also removed required minimum distributions (RMDs) on Roth 401(k) accounts. This adds another feature that made Roth IRAs popular. RMDs force retirees to withdraw a minimum amount of their retirement accounts over time. For tax-deferred accounts like traditional IRAs and 401(k), RMDs trigger a tax payment. It makes sense that the IRS would require this rule to ensure that they're getting paid, but it removes flexibility in retirement planning for some households. The change does not take effect until 2024, but it will eliminate some of the remaining disparities between the two accounts.
There's no perfect account for everything
Remember, the features of each account make it better for some purposes and worse for others. Your individual circumstances dictate the best financial tools for you.
The Roth 401(k) does have some limitations relative to its IRA counterpart. Roth IRA contributions can be withdrawn without penalty at any time, because the account is funded with after-tax dollars. Early-withdrawal penalties in these accounts apply only to gains. A Roth 401(k) does not offer the same early-withdrawal flexibility, so it can functionally lock savers out of their own assets if they overextend.
Roths aren't always the most appropriate option, either. People facing high tax rates are often better off taking a deferral and anticipating a lower tax rate in retirement. These people would generally benefit more from a traditional 401(k) with pre-tax contributions.
The value of a Roth also hinges on asset growth. Bonds and low-volatility assets that aren't optimized for high returns won't maximize the Roth's tax benefits. In many cases, it's smart to house different assets in different accounts to maximize efficiency across your retirement portfolio as a whole.