Saving for retirement in a Roth 401(k) will give you a tax-free source of retirement income. You also won’t need to pay income tax on the investment growth within the account.
Here’s why you should consider using a Roth 401(k) to save for retirement:
— You can avoid paying income tax on investment gains.
— Withdrawals in retirement are often tax-free.
— You can pay your current tax rate on your retirement savings instead of an unknown future tax rate.
— Your employer may provide a pretax 401(k) match.
What Is a Roth 401(k)?
A Roth 401(k) is a workplace retirement account that provides participants with tax advantages. When you contribute after-tax dollars to a Roth 401(k), you become eligible to accumulate tax-free investment growth and to take tax-free withdrawals after age 59 1/2 from an account that is at least five years old.
[READ: How Much Should You Contribute to a 401(k) in 2024?]
What Is the Difference Between a Roth 401(k) and Traditional 401(k)?
A traditional 401(k) allows you to defer paying income tax on your retirement savings until you withdraw the money from the account. A Roth 401(k) only accepts after-tax contributions, but the money will grow tax-free and you can take tax-free withdrawals in retirement.
If your employer offers both a traditional and Roth 401(k), you can decide when to pay tax on your retirement savings.
With a traditional 401(k), you contribute pretax dollars, meaning your tax liability goes down. Your money grows tax-deferred until you begin making withdrawals. Those withdrawals are taxed at the ordinary income rate.
With a Roth 401(k), on the other hand, you make after-tax contributions, meaning there’s no immediate tax advantage. However, down the road, your withdrawals of both contributions and earnings are tax-free after you turn 59 1/2 and if you’ve owned the account for at least five years.
If you aren’t sure whether you will pay a higher tax rate now or in the future, you can hedge your bets by saving in both accounts. You can contribute to a traditional and Roth 401(k) in the same year as long as your contributions to both types of accounts don’t exceed the IRS 401(k) contribution limit for that year.
“A Roth 401(k) makes a lot of sense for a younger person, especially someone that is in the lower tax brackets. The compounded, tax-free growth and withdrawals are the biggest benefit,” says Michael Hakimi, a certified financial planner and owner of Black Dog Financial Planning in Mount Pleasant, South Carolina. “I would consider sticking to traditional 401(k) contributions if the employee is a high earner.”
What Are the Roth 401(k) Contribution Limits?
The Roth 401(k) contribution limit is $22,500 in 2023 and $23,000 in 2024.
Employees age 50 and older can make additional catch-up contributions of up to $7,500 for in 2023 and 2024.
[New 401(k) Contribution Limits for 2024]
Is There a Roth 401(k) Match?
Some employers match Roth 401(k) contributions, but the company contribution won’t be put in the Roth account. The 401(k) match will be deposited in a traditional 401(k) account, and you will owe income tax on the employer contributions and the investment earnings when you withdraw the money from the account.
“The terms of your employer’s retirement plan should outline whether they provide a match for Roth contributions and the details of how it’s allocated,” said Walter Russell, president of Russell and Company in New Albany, Ohio, in an email.
“I’d recommend you review your employer’s 401(k) plan documents or speak with the HR department to understand the specifics of the matching program offered within your company’s Roth 401(k) plan,” he added.
Do You Have to Take Roth 401(k) Withdrawals in Retirement?
Roth 401(k) withdrawal rules have changed in the past few years. Beginning in 2023, the SECURE 2.0 Act raised the age that you must begin taking distributions from a Roth 401(k) to 73 from 72. However, starting in 2024, Roth 401(k)s are no longer subject to required minimum distributions, or RMDs.
Many retirement savers roll their Roth 401(k) balance over to a Roth IRA, which means it’s no longer part of an employer’s program. A Roth IRA doesn’t have any withdrawal requirements in retirement.
What Is the Difference Between a Roth 401(k) and a Roth IRA?
You can only participate in a Roth 401(k) if your employer provides one.
Roth IRAs are available to people with earned income whose adjusted gross income is less than $153,000 as an individual or $228,000 as a married couple in 2023. Those thresholds rise to $161,000 and $240,000 in 2024.
“If your income is too high and you’re unable to contribute to a Roth IRA but would like to, you can still contribute to a Roth 401(k), as they are not subject to income limitations,” says Joseph Piela, a certified financial planner and partner at Sax Wealth Advisors in Parsippany, New Jersey.
Roth 401(k)s have a much higher contribution limit than Roth IRAs. In 2023, you may contribute up to $22,500 in a Roth 401(k). That increases to $23,000 in 2024. Savers 50 and older may contribute an additional $7,500 in 2023 and 2024.
Savers can only contribute up to $6,500 to a Roth IRA in 2023, and up to $7,000 in 2024. The catch-up contribution is limited to another $1,000.
Roth 401(k)s have an earlier contribution deadline than Roth IRAs. Roth 401(k) deposits generally need to be made by the end of the calendar year, but you have until your tax filing deadline to make Roth IRA contributions.
[Read: How to Open a Roth IRA.]
Is It Smart to Have a Traditional 401(k) and a Roth 401(k)?
The choice to go with a traditional 401(k), Roth 401(k) or both depends on an investor’s financial circumstances, tax situation and retirement goals, Russell said.
If you’re deciding between a Roth 401(k) and traditional 401(k), consider your current and future tax obligations. You might choose a Roth if you anticipate higher taxes in retirement or choose traditional if you expect your taxes to be lower. Investors frequently underestimate their tax burden in retirement, so evaluate those scenarios carefully, perhaps with the help of a financial planner or tax advisor.
“Your advisor should be able to run three separate plans to help illustrate which choice makes the best for your financial and retirement goals,” Russell said.
Are There any Downsides to a Roth 401(k)?
While Roth 401(k)s offer tax-free withdrawals in retirement, the biggest potential downside is the lack of an immediate tax benefit.
Contributions are made after tax, which affects your take-home pay amount. Additionally, high earners face contribution restrictions.
If you make an early withdrawal, you may face penalties.
As with so many investing decisions, the choice between Roth and traditional 401(k) ultimately comes down to your individual circumstances.
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A Guide to Your Roth 401(k) originally appeared on usnews.com
Update 12/26/23: This story was published at an earlier date and has been updated with new information.
