One of the best things you can do to grow your future wealth is to participate in an employer’s retirement plan. By making consistent contributions to your retirement savings in this way, you can build a nest egg over time and will be more likely to reach your long-term financial goals.
Although many people are familiar with traditional 401(k) plans, your employer might provide access to another choice: the Roth 401(k). Here’s what you need to know about how a Roth 401(k) works and whether you should use the Roth 401(k) as part of your retirement plan.
What is a Roth 401(k)?
The Roth 401(k) was created by congressional legislation in 2001, and employers had the option to begin providing these plans to their workers in 2006. The idea behind a Roth 401(k) was to combine some of the features of the traditional 401(k) with the tax benefits of a Roth IRA.
Creating a Roth version of the 401(k) provides employees with another choice when it comes to building a retirement nest egg. It gives them a way to take advantage of higher 401(k) contribution limits while still getting the same tax-free growth associated with a Roth account.
Let’s look in more detail at how a Roth 401(k) works, why contribution limits matter, and the potential tax advantages.
How a Roth 401(k) works
First, you can participate in a Roth 401(k) only if your employer offers the choice. However, there is a decent chance your employer provides a Roth option if they provide retirement benefits. The Society for Human Resource Management reports that 59% of employers that offer plans also provide a Roth option. If you’re interested in making Roth 401(k) contributions to your retirement account, talk to your human resources department to see whether it’s a possibility.
Using a Roth 401(k) is fairly straightforward and similar to making traditional 401(k) contributions:
- You designate how much of your paycheck you want to be withheld for your Roth 401(k).
- Your money is taken out of your check with after-tax dollars, so income tax will be deducted from your paycheck before you make your Roth 401(k) contribution.
- Money in your Roth account grows tax-free over time.
- When you withdraw money from your Roth 401(k) during retirement, you won’t pay taxes on the amount, as long as you are at least 59 1/2 years old and your account has been established for five years.
- There are required minimum distributions you need to start taking when you reach age 72, but you won’t pay taxes on those distributions.
If you believe your tax burden or income tax rates, in general, will be higher in the future, it can make sense to put some of your money into a Roth 401(k). The idea is that you pay taxes today, at what you believe is a lower rate, and then you don’t have to pay taxes on the withdrawals during retirement. However, it’s a good idea to consult with a tax planning professional before deciding how much you’ll set aside in a Roth 401(k).
The benefits of a Roth 401(k)
If you have access to a Roth 401(k), there are a number of potential benefits, especially if you like the idea of a Roth IRA, but you don’t like the low contribution limit or you are subject to the income limits associated with IRAs.
Here are some of the benefits you’re likely to see associated with a Roth 401(k) plan:
Higher contribution limits
Contribution limits for the Roth version of a 401(k) are the same as with the traditional 401(k), which is $19,500 for 2020. This is much higher than the contribution limit of $6,000 for the Roth IRA. Plus, if you are at least 50 years old, you can make a catch-up contribution of $6,500 in 2020. Compare that to the Roth IRA, where the catch-up contribution is only $1,000.
If you want the long-term tax benefits of a Roth account, being able to contribute (if you’re at least 50) a total of $26,000 to your retirement account, rather than being stuck with the $7,000 limit of the Roth IRA can be a huge benefit.
No income rules for contributions
You don’t have to worry about your income limiting your contributions. With a Roth IRA, you can’t contribute once you cross a certain income threshold (which changes each year). The Roth 401(k) doesn’t impose such limitations. If you make too much to qualify for Roth IRA contributions, making Roth contributions to your 401(k) plan can be a way to get the benefits associated with a Roth account.
Easily roll over to a Roth IRA
If you want to roll over money from your Roth 401(k) into a Roth IRA, you can do so without any trouble. Because the Roth 401(k) and Roth IRA are treated the same in terms of taxation, this process would be a direct rollover and you wouldn’t have to worry about dealing with tax consequences.
This is also one way that some investors create a sort of back-door Roth IRA. If you can’t contribute to a Roth IRA due to income limitations, you can make Roth 401(k) contributions, and then later roll the money over into a Roth IRA. Then you can still get the advantages of a Roth IRA, even if you wouldn’t normally be eligible to open and contribute to that type of account.
Withdrawals are tax-free
Because you contribute after-tax dollars to a Roth 401(k), your withdrawals later are tax-free. This allows you to increase the tax efficiency of your compounding returns. However, in order to get the full benefits of these tax savings, you need to wait until age 59 1/2 to withdraw money from the account, and the account needs to have been established for at least five years.
You can take out a loan against your savings
Because it’s a 401(k), it’s possible to take a loan against your Roth account. However, the availability, as well as the terms and conditions, are up to your employer. Not all employers allow 401(k) loans, so you need to check with your plan sponsor or administrator before moving forward.
Also, be aware of the pitfalls involved with doing something like using a 401(k) loan to pay off debt. If you lose or leave the job associated with that 401(k) before you’ve paid off the loan, the outstanding amount will become due. At that point, you’d have to replace all the funds or risk paying penalties.
Roth 401(k) vs. traditional 401(k)
For the most part, the addition of the Roth option for 401(k) contributions provides workers with the chance to take advantage of some of the tax benefits associated with a Roth account. There are some similarities between the accounts, as you’d expect. Contribution limits are the same for both types of accounts, and you have to take RMDs at age 72.
But there are some key differences between a Roth 401(k) and a traditional 401(k), and it’s important to understand them before you move forward.
With a traditional 401(k), you’re making pre-tax contributions. This means your contribution is taken out of your paycheck before taxes are calculated. As a result, your gross income is reduced and you receive a tax deduction for your contribution to a traditional account. This can reduce your tax liability today, and leave you with a little more money in your paycheck.
Money in a traditional 401(k) grows on a tax-deferred basis until you withdraw it from your account later. When you make withdrawals, you will pay taxes at your marginal tax rate at the time of the withdrawal. For those who expect to be in a lower tax bracket in retirement or expect lower tax rates in the future in general, this could be a good strategy.
With a Roth 401(k), on the other hand, you make contributions with after-tax money. You pay now and don’t get a tax break today, but you also don’t have to pay taxes on your withdrawals. This means your earnings can grow tax-free. If you predict your tax burden will be higher in the future, this could be a good way to go.
You can roll over a 401(k) into an IRA fairly easily. Realize, though, that you need to make sure you’re rolling your accounts into an IRA with the same tax treatment. For example, if you try to roll a traditional 401(k) into a Roth IRA, you’ll be hit with a tax bill, as you have yet to pay taxes on those 401(k) contributions.
When completing a rollover, you might first consider consulting a tax professional or financial advisor. You’ll likely want to roll Roth 401(k) funds into a Roth IRA and traditional 401(k) funds into a traditional IRA if you want things to be as simple as possible and to maintain a consistent tax situation.
One thing to be aware of when deciding on a Roth 401(k) is to realize that, though an employer can still match your contributions, the employer’s portion will actually go into a traditional 401(k).
Let’s say your employer offers a 50% match on up to 6% of your income. Let’s say you make $1,500 in a paycheck. If you want the full match, you’ll make a contribution of $90. That money will go into the Roth 401(k). The company match of $45, however, will not go into your Roth account. Your employer’s contribution will go into a traditional 401(k).
So if you have an employer match and you contribute to a Roth 401(k), you’ll still end up with a traditional account as well. The money your company deposits is free to you, and the earnings from the compounding returns are also free to you, so this strategy is still an advantage. However, you’ll have to pay taxes when you withdraw the money down the road — even though your withdrawals from your Roth 401(k) will be tax-free.
Deciding how much of your employee contributions should go toward a Roth account and how much should go toward a traditional account depends on your situation and your long-term personal finance goals. A retirement professional can help you work through which accounts you should withdraw from first later on, as well as help you create a plan that maximizes your tax savings.
If you want access to a Roth account, but don’t like the low contribution limits or income restrictions that come with an IRA, you might be able to gain some of those benefits with the help of a Roth 401(k). Check with your employer to see whether that’s an option, and consider your long-term financial situation to decide if it makes sense to start making Roth 401(k) contributions.