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What Is a Roth 401(k) and How Does This Retirement Plan Work?


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For years, the traditional 401(k) plan has been the most popular workplace retirement account. However, there’s a newer alternative that’s grown steadily in the past decade: the Roth 401(k). According to CNBC, 86% of employers offered this plan in 2020, up from just 49% in 2010.

If your employer is one of them, you’ve probably wondered which type of plan is better. As with so many financial questions, the answer is, “It depends.” 

To understand just what it depends on, you’ll need to dive into some details about how the Roth 401(k) works and what sets it apart from its traditional cousin.


What Is a Roth 401(k) Plan?

A Roth 401(k) is a retirement plan that combines the convenience of a traditional 401(k) with the tax benefits of a Roth IRA.


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When you contribute to a traditional 401(k), the money comes out of your pretax earnings. It grows tax-free in your account throughout your working years, and you pay no tax on it until you reach retirement. 

With a Roth 401(k), the tax benefits are exactly the opposite. You contribute to the plan using after-tax dollars. But when you retire, you pay no income tax on your withdrawals from the account.

For example, say that at age 35, you contribute $10,000 to a Roth 401(k). You cannot deduct any of this $10,000 from your income taxes. If you’re in the 24% tax bracket at the time, you’ll pay $2,400 in taxes on the money before contributing it.

Now suppose that by the time you retire at age 65, that $10,000 contribution has grown to $75,000. You can withdraw that entire sum without paying taxes on it. If you’re still in the 24% bracket, that’s $18,000 in income taxes that you can avoid.

Pro tip: If you have a Roth 401(k) or traditional 401(k) through an employer, make sure you sign up for a free analysis from Blooom. They’ll make sure you have the right allocation and are properly diversified. They also analyze the fees you’re paying. Sign up for your free Blooom analysis.


How Does a Roth 401(k) Plan Work?

Contributing to a Roth 401(k) is easy. Contributions come out of your paycheck automatically, just as they do with a traditional 401(k) but with after-tax dollars. The limit on how much you can contribute to a Roth 401(k) is the same as for a traditional 401(k).

You can invest your Roth 401(k) contributions in whatever choice of funds your employer offers. Like other 401(k) plans, the plans usually include a range of stock and bond mutual funds and target-date funds. You pay no tax on the earnings from your investments as they grow. 

At retirement, you can start to withdraw the money from your Roth 401(k) tax-free, just as you would with a Roth IRA. You can begin to take “qualified distributions” from a Roth 401(k) at age 59 ½. There are also other limits on Roth 401(k) withdrawals, which are discussed below.

There’s one exception to these tax benefits: employer matching contributions. Like other 401(k) plans, the Roth 401(k) allows employers to match a portion of your contributions. But unlike your own contributions, your employer’s are always made with pretax dollars.

If you have a Roth plan, pretax contributions from your employer go into a separate, traditional 401(k). When you withdraw money from this secondary account in retirement, it’s taxed as ordinary income.


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

Both traditional and Roth 401(k) plans shelter some of your income from taxes, but they do it at different times. So choosing between a traditional and a Roth 401(k) is largely a matter of deciding which matters more to you: saving money now or having more money later.

Roth 401(k) Plans and Your Tax Bracket

Some experts say a traditional 401(k) makes sense if you think your income tax rate in retirement will be lower than your current tax rate. If you’re at the peak of your earning power, you probably expect to have a lower income in retirement and thus be in a lower tax bracket.

By contrast, if you’re a young worker on a starting salary, you probably assume that your income will place you in a higher tax bracket in retirement. Thus, it makes more sense to pay your taxes upfront with a Roth 401(k).

But others argue that a Roth 401(k) can make sense for older workers as well. They point out that even if your income tax bracket is lower in retirement, withdrawals from retirement accounts could push you into a higher tax bracket. With a Roth 401(k), you don’t face this risk.

Having a higher taxable income in retirement doesn’t just increase your tax bill. It can also increase the amount you pay for Medicare. Premiums for both part B and part D vary based on income. As of 2022, you pay more if your taxable income exceeds $91,000 per year.

There’s also the possibility that tax rates as a whole will rise between now and your retirement. Some economists argue that the government will need to increase taxes at some point in order to pay for the growing cost of programs such as Medicare and Social Security.

If that happens, people who invested in traditional 401(k)s could find themselves paying much higher taxes in retirement than they would have paid during their working years. But those who chose a Roth 401(k) and paid their taxes upfront will avoid these higher taxes.

Roth 401(k) Plans and Your Maximum Contribution

Predicting your future tax rate is a tricky business. For many people, it makes more sense to think about how much you can afford to invest right now. 

One thing is certain: If you fund your 401(k) plan up to the maximum, you’ll end up with more money by choosing a Roth 401(k). Both plans will contain the same amount of money when you retire. But with a Roth, all that money will be tax-free.

However, if you can only afford to give up a certain amount of your take-home pay each month  — say, $300 — you’ll end up with more in your account by choosing a traditional 401(k) plan. That’s because the entire $300 will go into your investments, with none lost to taxes.

Of course, you’ll have to pay tax on the money when you withdraw it. However, you can adjust the amount you withdraw per year to keep your taxes low. By contrast, if you use a Roth 401(k), you have to pay taxes now based on your current earnings.

To see how the math works on this, check out this 401(k) calculator from CalcXML. Click on “Show All Input” and select “Option 1.” You can adjust the figures for your contribution, current tax rate, and tax rate in retirement to see how they affect your future benefits.

Combining Traditional and Roth 401(k) Plans

If you’re not sure whether a traditional 401(k) or a Roth 401(k) is better for you, you can hedge your bets by using both. You can switch back and forth between traditional and Roth 401(k) contributions from year to year. Some employers even allow you to split your contributions for a single year between the two plans.

Using both types of plan gives you more control over how much income tax you pay. For example, suppose you get a raise that would bump you into a higher tax bracket. By putting more into your traditional 401(k), you can keep your taxable income lower.

You can also use the two plans to adjust your taxable income in retirement. Each year, you can take withdrawals from your taxable 401(k), your tax-free Roth account, or a combination of the two.


Roth 401(k) Plan Contribution Limits

The limits on contributions are the same no matter which type of 401(k) you use. For the tax year 2022, the maximum you can contribute is $20,500. If you’re age 50 or older, you can put in an extra $6,500 each year as a “catch-up contribution,” raising the total limit to $27,000.

This $20,500 maximum is for employee contributions only. Your employer’s matching contributions don’t count toward the limit. 

However, there is an additional, higher limit on employee and employer contributions combined. For 2022, this combined limit is equal to $61,000 or 100% of your salary, whichever is lower. The catch-up contribution raises the limit to $67,500 for employees over 50.


Roth 401(k) Plan Withdrawal Rules

When you withdraw money from a Roth 401(k), you pay no taxes if it is a qualified distribution. This means it meets two criteria: you are at least 59 ½ years old and you have had your Roth account for at least five years. 

You can also make tax-free withdrawals in cases of hardship. For example, you can take money out before age 59 ½ if you are disabled. Your beneficiary can withdraw it if you die. Some plans also allow tax-free withdrawals for special purposes, such as to cover high medical bills.

If you withdraw funds from your Roth account without meeting these rules, it’s called an unqualified or non-qualified distribution. In this case, you owe income tax and a 10% penalty on some — but not all — of the money you withdraw. 

Rules for Early Withdrawals 

When you withdraw money from a traditional 401(k) early, you pay a penalty equal to 10% of the withdrawal, in addition to any tax you owe. With a Roth 401(k), by contrast, the tax and penalty are due on only part of the money.

That’s because your Roth 401(k) account has two kinds of money in it: the money you’ve contributed and the earnings on your investments. The contributions have already been taxed because you funded the account with after-tax dollars. But the earnings have not. 

When you take an early withdrawal from your Roth 401(k), part of the money comes out of your contributions, and you do not need to pay tax on it. The rest of the withdrawal comes out of your yat-untaxed earnings, so it is subject to tax and the 10% penalty.

For instance, suppose you’ve contributed a total of $18,000 and your balance is now $22,500. That means the other $4,500, or 20% of the total, is earnings. If you make an early withdrawal of $3,000, you owe tax and a penalty on 20% of that amount, or $600.

Required Minimum Distributions

You can’t let money build up tax-free in your 401(k) account forever. Once you reach a certain age, you must stop putting money into your account and start taking money out. Each year, you must withdraw a specific amount known as the required minimum distribution, or RMD. 

Both traditional and Roth 401(k)s require RMDs. In most cases, you must begin taking RMDs on April 1 of the year after you turn 72. If you were born before July 1, 1949, you must start taking RMDs the year after you reach age 70 ½.

If you’re still working when you reach the required age, you can delay taking RMDs until you retire. However, you can only do this if you’re working for a company that you don’t have an ownership stake in. That means you don’t own 5% or more of its stock.

Another way to avoid taking RMDs is to roll over your Roth 401(k) plan into a Roth IRA, as discussed below. However, if the Roth IRA account you use isn’t at least five years old, you must wait until it is before you can take qualified distributions from it.


Advantages of a Roth 401(k) Plan

Compared to other ways of saving for retirement, Roth 401(k) plans offer several major perks. These include:

  1. No Taxes in Retirement. You pay no taxes on the funds you withdraw from your Roth 401(k) after retirement. This is a particularly good deal if you’re in a high tax bracket when you retire.
  2. Tax-Free Earnings. The funds in your Roth 401(k) also grow tax-free throughout your working years. Your investments grow faster without yearly taxes eating away at them.
  3. Convenience. Like a traditional 401(k), a Roth account makes investing automatic. Money comes straight out of your paycheck. It’s easy and painless because you don’t feel the loss of money that was never in your hands.
  4. Employer Matching. Employer matching contributions are basically free money. They help your retirement savings grow even faster.
  5. Control Over Investments. Most Roth plans offer a choice of funds to invest in. You can customize your plan to fit your investing style

Disadvantages of a Roth 401(k) Plan

Roth 401(k) plans also have some drawbacks compared to other retirement plans, such as traditional 401(k) plans and Roth IRAs. These include:

  1. No Upfront Tax Savings. A Roth 401(k) can’t reduce your tax bill immediately the way a traditional 401(k) can. Because it’s funded with after-tax dollars, contributions take a bigger bite out of your take-home pay.
  2. Limited Access to Funds. You can’t take qualified distributions from your Roth account until you’re 59 ½. True, the penalty for an early withdrawal is smaller than it is for a traditional 401(k). But it still restricts your access to your money.
  3. Limited Investment Options. You can choose your investments in a Roth 401(k), but your choices are limited. The available funds may not cover certain types of investments, such as real estate. And they often come with high fees.
  4. Plan Fees. Most 401(k) plans, both traditional and Roth, come with high fees. They typically take a cut of 1% to 2%, while taxable plans charge around 0.5%.
  5. Limited Availability. You can only open a Roth 401(k) through your workplace. If you’re self-employed or your employer doesn’t offer this type of plan, it’s not an option for you.

Frequently Asked Questions (FAQs)

Roth 401(k) plans are a complicated and sometimes confusing subject.  Here are some of the questions investors often ask about them.

What’s the Difference Between a Roth 401(k) and a Roth IRA?

Like a Roth 401(k), a Roth IRA plan allows you to withdraw your money tax-free after you retire. However, these two plans are quite different in other ways, including:

  • Contribution Limits. The maximum you can contribute to a Roth IRA is $6,000 per year, or $7,000 if you’re age 50 or over. With a Roth 401(k), you can contribute up to $20,500 per year, or $27,000 if you’re over 50.
  • Income Limits. If your income is over a certain level, you can’t contribute to a Roth IRA at all. For 2022, this limit is $144,000 if you’re single or $214,000 for a couple filing jointly. There are no income limits for a Roth 401(k).
  • Early Withdrawals. With a Roth IRA, you can withdraw your contributions (but not your earnings) with no penalty after five years. With a Roth 401(k), you must pay a penalty on a portion of all early withdrawals.
  • Qualified Distributions. Both plans have similar rules for qualified distributions. However, the Roth IRA also allows tax-free distributions for the purpose of buying your first home.
  • Required Minimum Distributions. Unlike a Roth 401(k), a Roth IRA does not require you to start taking RMDs when you reach age 72 or retire. The money can remain in your account and continue to grow tax-free as long as you live.

How Do You Start a Roth 401(k)?

You can only open a Roth 401(k) if your employer offers it. If this plan is available, your employer will probably offer you the choice to enroll when you start work. They should provide the necessary paperwork to get you started.

If you currently have a regular 401(k) and would like to switch to a Roth 401(k) — or use both — visit your company’s human resources department. They can tell you if this plan is available and how to sign up.

Can I Roll Over a Roth 401(k)?

If you change jobs, you can roll over your Roth 401(k) into a new Roth account with your new employer, assuming they offer this type of plan. You can also roll it into a Roth IRA at any time.

If you roll over your Roth 401(k) into an existing Roth IRA that’s at least five years old, you can take qualified distributions from this plan with no penalties. But if you roll it over into a brand-new Roth IRA, you must wait five years to take qualified distributions.

What Is the Penalty for Withdrawing From a Roth 401(k) Early?

The penalty for early withdrawals from a Roth 401(k) depends on the balance of contributions and earnings in the account. If 20% of the money in the account is from earnings, then you owe a 10% penalty on 20% of the money withdrawn early.

For instance, suppose you make an early withdrawal of $3,000. If the money in your account is 20% earnings, you owe a penalty on the first 20% of that $3,000, or $600. The penalty is 10% of that $600, or $60.


Final Word

Today, the majority of companies that offer 401(k) plans have a Roth option. The choice between this option and a traditional 401(k) comes down to when you want to save on taxes: now or later.

A Roth 401(k) offers a bigger payoff if you expect your taxes to be higher in retirement than they are now. This could be the case if you’re a young worker with a low income, or if you think income tax rates in general are going to rise before you retire.

However, contributing to a Roth plan means more financial pain in the short term. Putting $100 to a Roth 401(k) costs you more than putting it into a traditional 401(k) because the money is taxed first. That can make the traditional plan a better choice if you’re on a tight budget.

Traditional and Roth 401(k) plans aren’t your only choices for your retirement nest egg. Check out our other articles to learn about other types of retirement savings plans such as traditional IRAs, SEP IRAs and SIMPLE IRAs for small-business owners, and solo 401(k) plans for self-employed people.

Amy Livingston is a freelance writer who can actually answer yes to the question, "And from that you make a living?" She has written about personal finance and shopping strategies for a variety of publications, including ConsumerSearch.com, ShopSmart.com, and the Dollar Stretcher newsletter. She also maintains a personal blog, Ecofrugal Living, on ways to save money and live green at the same time.

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