The Roth 401(k) is a relatively new employer-sponsored retirement savings vehicle. But while it’s growing in popularity, people still aren't as familiar with the Roth 401(k) as they are with its cousin, the traditional 401(k). The difference comes down to how your retirement savings are taxed. This is an important distinction because it determines how much of your money you have to give back to the government and when.
Here's a closer look at how a Roth 401(k) works, its advantages, and how to decide whether this type of account is a good place for your retirement savings.
What is a Roth 401(k)?
A Roth 401(k) is a type of employer-sponsored retirement account funded by after-tax dollars. It shares features with the traditional 401(k), including its high contribution limits and lack of eligibility restrictions based on income, and the Roth IRA, which also allows for after-tax retirement contributions and tax-free withdrawals in retirement.
Advantages of a Roth 401(k)
There are several advantages to Roth 401(k)s:
Roth IRAs are a great fit for people who think they will be in the same tax bracket or a higher one once they retire. Distributions from these accounts are tax-free. You pay taxes on your contributions the year you earn the money, so the government leaves the money alone afterward and largely lets you use it as you see fit.
Paying taxes while you're in a lower tax bracket will reduce the percentage of your income you must give back to the government, enabling you to keep more of your savings. Even if you think you're in the same tax bracket now as you will be when you enter retirement, you'll still likely pay less because you'll owe taxes only on the contributions, not the earnings.
High contribution limits and employer matching
Roth 401(k) contribution limits (see below) are high and enable you to set aside larger sums for retirement than you could if you were using a Roth IRA. Some employers match contributions to a Roth 401(k). However, company 401(k) matches must be made pre-tax and go into a traditional 401(k) account.
No income limitations
You may contribute to a Roth 401(k) regardless of how much income you earn throughout the year. This is in contrast to the Roth IRA, which accepts contributions only from individuals with modified adjusted gross incomes (MAGIs) of less than $139,000 and married couples with MAGIs below $206,000 in 2020. In 2021, these income limits increased to $140,000 for individuals and $208,000 for married couples. So a Roth 401(k) is a nice workaround for high earners who want to take advantage of after-tax retirement contributions without jumping through all the hoops required for a backdoor Roth IRA.
An easy way around required minimum distributions (RMDs)
Legally, you must take required minimum distributions (RMDs) annually from your Roth 401(k) once you turn 72, but you can get around this by rolling your funds into a Roth IRA. You can leave your money in a Roth IRA for as long as you'd like; it will continue to grow, and you can withdraw it tax-free when you're ready.
Roth 401(k) vs. traditional 401(k)
Traditional 401(k)s are funded with pre-tax dollars, while Roth 401(k)s are funded with after-tax dollars. A contribution to a traditional 401(k) reduces your taxable income, lowering your tax bill in the years you make the contributions. But then you must pay taxes on your distributions once you retire.
A traditional 401(k) makes the most sense if you believe you're in a higher tax bracket today than you will be in once you retire. By delaying taxes until retirement, when your taxable income is lower, you'll reduce the amount you owe the government.
Both traditional and Roth 401(k)s limit withdrawals before 59 1/2, but a Roth 401(k) allows a little more flexibility. If you withdraw funds from a traditional 401(k) before this age, you'll pay taxes, plus a 10% early withdrawal penalty. This penalty is waived if the withdrawal is made for a qualifying reason, such as to pay an educational expense, a first-home purchase, or a large medical bill.
A Roth 401(k) allows for tax- and penalty-free withdrawals of contributions before 59 1/2, although you could still owe taxes and penalties if you attempt to withdraw your Roth 401(k) earnings before this age. You can also owe taxes and penalties on your earnings if you haven't had a Roth retirement account for at least five years, even if you're older than 59 1/2.
In all other ways, a traditional 401(k) and a Roth 401(k) are the same. Both allow employer matching and annual contributions up to the limits discussed below, and they allow employees of any income level to participate.
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Roth 401(k) limits
Adults younger than 50 may contribute up to $19,500 to a Roth 401(k) in 2020 and 2021, and adults 50 or older may contribute up to $26,000. These are the same limits that apply to a traditional 401(k), and both are much higher than the $6,000 ($7,000 with the catch-up contribution for adults 50 or older) that you're allowed to contribute to an IRA in 2020 and 2021.
Keep in mind the above limits apply to all 401(k) accounts that you own, so if your company offers both a traditional and a Roth 401(k), you may contribute only $19,500 in total, not $19,500 to each. But you are free to decide how you would like to split the money between the two types of retirement accounts.
The many benefits of a Roth 401(k) can make this type of account a valuable addition to your overall retirement plan.