What is a Roth 401(k)?

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A Roth 401(k) is a retirement savings plan that blends features of a traditional 401(k) and a Roth IRA. With a traditional 401(k) you would contribute pre-tax dollars and then make taxable withdrawals in retirement. With a Roth 401(k) it works differently, because you will be contributing post-tax dollars and when you make withdrawals they are tax-free.

The Roth 401(k) allows you to contribute after-tax dollars, meaning you don’t get an immediate tax break on contributions, but withdrawals during retirement are tax-free, including the earnings, if you meet certain conditions. This account is available through employer-sponsored plans and is ideal for those who anticipate being in a higher tax bracket during retirement. If you instead anticipate being in a lower tax bracket during retirement than you are now, the Roth 401(k) is most likely a bad choice.

The Roth 401(k) retirement savings plan was authorized by the U.S. Congress under the Internal Revenue Code, section 402A. Since the start of 2006, employers in the U.S. have been permitted to amend their existing 401(k) document and allow employees to chose a Roth 401(k) for all some or all of their retirement plan contributions. Providing access to Roth 401(k) for their employees is not something an employer is required to do – it is up to each employer to decide. For many employers, the additional administrative burden is a strong argument against offering Roth 401(k) plans.

If you are working for an employer that do offer the Roth 401(k) option, this type of retirement account can be a powerful retirement savings vehicle if you want tax-free income in retirement. It is also worth knowning that if you are self-employed, even if it is just part-time, you may be eligible to establish your own independent 401(k) and designate the money you contribute to it as Roth contributions (post-tax contributions). If you qualify as a sole proprietor, you will access higher contribution limits than the normal ones for 401(k) plans.

By paying taxes upfront, Roth 401(k) holders can avoid taxes on their investment growth, which can be especially beneficial if they expect to be in a higher tax bracket when they retire. While the lack of an immediate tax deduction may deter some, the long-term benefits of tax-free growth and withdrawals make the Roth 401(k) an attractive option for many investors. It can be especially useful for younger workers who are in a low tax bracket now and expect to be in a higher one in retirement.

Roth 401(k) holders

Key Features of a Roth 401(k)

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  1. After-Tax Contributions
    Unlike traditional 401(k) accounts, contributions to a Roth 401(k) are made with after-tax dollars. This means that while you don’t receive a tax deduction for your contributions, you will not pay taxes when you withdraw the money during retirement, provided the account is held for at least five years and withdrawals occur after age 59½. This tax treatment can be beneficial for individuals expecting to be in a higher tax bracket when they retire, allowing them to lock in today’s tax rate and avoid taxes on their gains.
  1. Contribution Limits For Employees There are limits for how much you can contribute to your 401(k) accounts each year. For 2024, employees can contribute up to $23,000 annually if they are under 50, and individuals aged 50 or older can make an additional catch-up contribution of $7,500, bringing their total contribution limit to $30,500. Important: These contribution limits apply to the combined total of any traditional 401(k) and Roth 401(k) contributions.
  2. Employer ContributionsEmployers can contribute to an employee’s Roth 401(k) through matching contributions. However, employer contributions are always made on a pre-tax basis, meaning they will go into a traditional 401(k) account and be taxed upon withdrawal in retirement. The employee’s portion of the contributions and the earnings on those contributions remain tax-free when withdrawn in retirement.
  3. Transfers Contribiutions to a Roth 401(k) are irrevocable in the sense that money placed in a Roth 401(k) account can not be transferred to a regular 401 (k) account. An employee can, however, roll their Roth 401(k) contributions over to a Roth IRA account if certain requirements are fulfilled.
  4. The Required Minimum Distributions (RMDs) Rule Has Been Removed Roth 401(k) accounts used to be subject to Required Minimum Distributions (RMDs) – you had to start receiving money from your Roth 401(k) as soon as you hit the age limit. Earlier, these Roth 401(k) distributions had to start at age 72, but this was changed to age 73 by the SECURE 2.0 Act of 2022, a change that took effect in 2023. To avoid the RMDs, many people rolled over their Roth 401(k) accounts into a Roth IRA. Since 2024, this is no longer a necessity, as the SECURE 2.0 Act of 2022 removed the requirement to take distributions from Roth 401(k) accounts, starting in 2024. In this sense, the Roth 401(k) has become much more smimilar to a Roth IRA.

Who Should Consider a Roth 401(k)?

  • Young Professionals: Roth 401(k)s are particularly advantageous for younger workers who are currently in lower tax brackets. Paying taxes now and locking in today’s tax rate can yield significant tax savings later, especially with decades of tax-free growth.’
  • High Earners: For those with higher incomes who are not eligible for a Roth IRA due to income limits, a Roth 401(k) allows you to contribute after-tax dollars and enjoy tax-free withdrawals in retirement without any income restrictions.
  • Individuals Who Anticipate a Higher Tax Bracket in Retirement: If you believe your tax rate will be higher when you retire than now, a Roth 401(k) makes sense. You pay taxes upfront, but withdrawals in retirement will be tax-free.

Benefits of a Roth 401(k)

  1. Tax-Free Withdrawals: One of the primary advantages of a Roth 401(k) is that all qualified withdrawals in retirement (both contributions and earnings) are tax-free. This provides significant savings if you expect to be in a higher tax bracket in retirement.
  2. High Contribution Limits: A Roth 401(k) allows higher annual contributions compared to a Roth IRA. The 2024 contribution limits for a Roth 401(k) are $23,000 for those under 50 and $30,500 for those 50 and older, compared to the $7,000 limit for Roth IRAs (with a $1,000 catch-up for those over 50).
  3. No Income Limits: Unlike Roth IRAs, which have income limits that restrict high earners from contributing directly, a Roth 401(k) has no income limits, allowing high earners to contribute the maximum amount regardless of their income.
  4. Tax Diversification: Many financial advisors recommend having a mix of tax-deferred and tax-free accounts in retirement to provide more flexibility in managing taxes. A Roth 401(k) offers a tax-free option to balance against traditional pre-tax retirement accounts.

Drawbacks of a Roth 401(k)

  1. No Immediate Tax Deduction: Unlike a traditional 401(k), contributions to a Roth 401(k) do not reduce your taxable income for the year in which you contribute. This can result in a higher current tax bill, especially for those in high tax brackets.
  2. Early Withdrawal Penalties: As with many other retirement accounts, early withdrawals (before age 59½) from a Roth 401(k) can result in a 10% penalty on the earnings, though contributions can be withdrawn tax-free at any time. You must also meet the five-year rule to withdraw earnings tax-free.

Roth 401(k) vs. Traditional 401(k)

Taxation: The primary distinction between a Roth 401(k) and a traditional 401(k) is how they are taxed. Contributions to a traditional 401(k) are made with pre-tax dollars, meaning you get a tax break upfront, but withdrawals are taxed as ordinary income in retirement. In contrast, a Roth 401(k) is funded with after-tax dollars, meaning your contributions are taxed today, but your withdrawals in retirement are tax-free.

Employer Match: For both Roth and traditional 401(k)s, employers can match contributions, but employer contributions are made pre-tax and go into a traditional 401(k) account. While employee contributions to a Roth 401(k) grow tax-free, the employer’s contributions and earnings will be subject to taxes when withdrawn in retirement.

Saving In a Roth IRA and In a Roth 401(k) At The Same Time

You are allowed to contribute to both a Roth IRA and a Roth 401(k) at the same time, if your income is low enough to not exceed the IRS´s treshhold amount.

Example:

  • If you do a $23,000 contribution to your Roth 401(k) each year for 20 years, and the average earnings are 5%, the amount will be roughly $800,000 after those 20 years. (In this scenario, the maximum amount permitted each year has not increased, and you have made no catch-up contributions.)
  • If you contribute $23,000 to your Roth 401(k) each year for 20 years, and $7,000 to your Roth IRA for 20 years, and the average earnings is 5% for each, the combined amount will be roughly $1 million. (In this scenario, the maximum amount permitted each year has not increased, and you have made no catch-up contributions.)

When you are above the age of 50, you will be allowed to contribute even more per year. As of 2024, the caps for individuals over 50 is a maximum of $30,500 to your 401(k) each year and a maximum of $8,000 to your Roth IRA each year. Instead of the $30,000 yearly in the example above, you could contribute a combined $38,500 each year.

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