Understanding Roth 401(k)
What is a Roth 401(k), how does it work, and when should you consider it?
By: Melissa Phipps
Melissa Phipps is a retirement planning and investment expert who has covered these topics for over 20 years as a writer, editor, and author. Her writings have appeared in Worth, Financial Planning, Financial Advisor, The American Lawyer, Institutional Investor, and numerous other publications.
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Updated on November 7, 2021
Reviewed by: Akhilesh Ganti
Fact-checked by: Emily Ernspurger
What is a Roth 401(k)?
A Roth 401(k) is exactly what it sounds like: it’s a blend of a 401(k) and a Roth IRA. Like a 401(k), it is offered by an employer. Contributions are deducted from your paycheck and can be invested for retirement in a number of designated investment options. Similar to a Roth IRA, contributions are made after taxes (as opposed to pre-tax contributions for a traditional 401(k)), but the money is not taxed again when it is withdrawn in retirement or after age 59½. It must be a qualified distribution to avoid taxes. You must also have invested for five consecutive years before withdrawing the money.
Roth 401(k) Contribution Limits
The contribution limits for a Roth 401(k) are the same as those for a regular 401(k). In 2021, you could contribute up to $19,500 to a Roth 401(k); these limits increase to $20,500 in 2022. If you are 50 years old or older, you can contribute an additional $6,500 in either year. Compare these maximum limits to those related to a Roth IRA: $6,000 per year in 2021 and 2022, with an additional $1,000 in catch-up contributions. There are few eligibility restrictions for a Roth 401(k).
Roth 403(b)
If you work for a nonprofit organization or a school, you may have seen the Roth 403(b) in your company’s retirement offerings. A Roth 403(b) works the same way as a 401(k), and a Roth 403(b) operates similarly to a Roth 401(k). You can make your decisions just as if you had a Roth 401(k).
Benefits of a Roth 401(k)
If you think that your taxes will be higher in retirement than they are today, a Roth 401(k) means a lot. You pay a lower tax rate on your investment dollars now, and you won’t pay any taxes in the future. For wealthy individuals who are not eligible for a traditional Roth IRA – single individuals whose modified adjusted gross income exceeds $140,000 in 2021 or $144,000 in 2022 are ineligible, as well as married couples filing jointly who earn more than $208,000 in 2021 or $214,000 in 2022 – a Roth 401(k) is a great way to take advantage of this retirement tax strategy.
With a traditional 401(k), when you take money out in retirement, you will pay a tax rate that ranges from 10% to 37% or more, depending on your tax bracket. You cannot predict the future direction of taxes, but if you expect to be in a higher income tax bracket during your retirement years, a Roth 401(k) may be more suitable.
Younger individuals who have not yet established a career path are more likely to see their taxes rise in the future, making a Roth 401(k) or Roth IRA a great way to save on future taxes. But if you are earning well now and expect your tax rate to drop significantly in retirement, a traditional 401(k) might be the better choice.
Disadvantages of a Roth 401(k)
But
Before you put all your retirement savings into a Roth 401(k), consider its biggest drawback compared to a 401(k): after-tax contributions. With a traditional 401(k), contributions are made before taxes, so there is no dollar-for-dollar impact on your salary. A 401(k) also provides a great way to reduce your taxable income and income tax bill without feeling a significant financial pinch. Since contributions to a Roth 401(k) are made after-tax, your salary will be impacted more. See the difference using a traditional 401(k) vs. Roth 401(k) calculator.
Transfers to Roth 401(k)
Aside from the major difference in after-tax contributions, Roth 401(k)s work the same way as regular 401(k)s. When you leave a job for another, you may have the option to keep your Roth 401(k) where it is with the former employer, transfer it to the new employer’s plan if a Roth 401(k) is offered there, or move it to a Roth IRA for conversion, where you will be subject to the same withdrawal rules.
What Should You Do?
You can contribute to both a 401(k) and a Roth 401(k), but contribution limits apply to the combined accounts. So should you move some of your 401(k) contributions to a Roth 401(k)? It really depends on the tax factors discussed above. You may want to continue aiming to maximize contributions to the regular 401(k) and have a non-employer-sponsored Roth IRA. If you don’t plan to contribute more than $6,000 to $7,000, a regular Roth IRA gives you the same benefits you would get with a Roth 401(k). If you can contribute to both types of retirement accounts, a combination of 401(k) and Roth IRA is a sensible option for financially successful individuals.
If you are really interested in the Roth 401(k) option, and your employer doesn’t currently offer it, ask them to add it. It doesn’t hurt, and it’s an additional investment option that can help you build a healthy financial future in retirement.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Internal Revenue Service. “Roth Comparison Table.”
Internal Revenue Service. “2022 Adjusted Limits as Described in Section 415(d), et al.” Page 1.
Internal Revenue Service. “2022 Adjusted Limits as Described in Section 415(d), et al.” Page 4.
Internal Revenue Service. “IRS Provides 2021 Tax Inflation Adjustments.”
Source: https://www.thebalancemoney.com/understanding-the-roth-401-k-2894163
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