When your employer offers an employer-sponsored retirement savings plan, you’ll want to understand the general benefits of taking advantage of a retirement plan. Saving for retirement allows you to better plan for your future. The more you can save during your working years, the more control you’ll have over your money when you decide to stop working.
But what type of retirement plan works best for you and what does your employer offer? Many companies offer employer-sponsored Roth 401(k) retirement accounts as well as traditional 401(k) plans. In this piece, we’ll walk through the definition of Roth 401(k) plans, how a Roth 401(k) works, the benefits of a 401(k), and the disadvantages and limits of a Roth 401(k).
By the time you’re done reading, you’ll have a better idea of whether a Roth 401(k) makes sense for your particular situation.
What is a Roth 401(k)?
A Roth 401(k) is an employer-sponsored after-tax contribution retirement account that blends characteristics of a Roth IRA and a 401(k).
When you authorize your company to take money out of your paycheck for a Roth 401(k), your company will take after-tax contributions. While you don’t receive a tax benefit up front, the goal is to receive tax-free withdrawals in retirement.
Specifically, withdrawals are not taxed as long as you make qualified distributions and the account is held for at least five years and made:
- on or after you reach age 59½
- due to a disability
- upon death of primary account holder
There are no income limits you have to meet in order to make a Roth 401(k) contribution. In other words, unlike a Roth IRA, you’re not disqualified to contribute once you make over a certain amount of income — a huge advantage.
It helps to compare Roth 401(k)s to two types of retirement savings vehicles — 401(k)s and Roth IRAs — to get an idea of the differences.
What’s the difference between Roth vs. traditional 401(k)? It comes down to tax treatment. In a traditional 401(k), each contribution comes out of your paycheck in pre-tax form and withdrawals in retirement are taxable.
Roth 401(k)s are also different from Roth IRAs, another type of retirement savings vehicle. The biggest similarity between both the Roth 401(k) vs Roth IRA is that your investments grow without being taxed at withdrawal, which could be a good option for someone whose income is likely to be higher in retirement than during their working years.
Let’s take a quick look at the differences among all three types of retirement savings vehicles — Roth 401(k)s, Roth IRAs and 401(k)s.
Comparing Roth 401(k)s, Roth IRAs and 401(k)s
|Roth 401(k)||Roth IRA||401(k)|
|Contributions||Elective contributions made with after-tax dollars||Contributions made with after-tax dollars||Elective contributions made with before-tax dollars|
|Income limits||No income limits||$214,000 modified adjusted gross income for married couples filing jointly in 2022 ($228,000 in 2023), $144,000 for single individuals in 2022 ($153,000 in 2023)||No income limits|
|Maximum contribution||Limited to $20,500 in 2022 ($22,500 in 2023) plus an additional $6,500 for employees age 50 or over||Limited to $6,000 ($6,500 in 2023) plus an additional $1,000 for employees age 50 or over||Limited to $20,500 ($22,500 in 2023) plus an additional $6,500 for employees age 50 or over|
|Taxation||Withdrawals are not taxed as long as you make qualified distributions and the account is held for at least five years and made due to a disability, on or after death or on or after you reach age 59½||Withdrawals are not taxed as long as you make qualified distributions and the account is held for at least five years and made due to a disability, on or after death or on or after you reach age 59½. You can always remove the contributions made to a Roth IRA without tax or penalty.||Contributions and earnings subject to federal and state income taxes upon withdrawal|
|Required distributions||Must take distributions no later than age 72 unless still working and not a 5% (or more) owner of the business sponsoring the plan||No requirements||Must take distributions no later than age 72 unless still working and not a 5% owner|
How Does a Roth 401(k) Work?
How does a Roth 401(k) work? In order to contribute to a Roth 401(k), you’ll need to indicate that you want to save money from your paycheck. You can do this by filling out an employee salary reduction agreement form, which also allows you to agree with automatic payroll deductions and indicate that you’d like to contribute after-tax dollars through a Roth 401(k). Some employers will match employee contributions up to a certain amount — check into your employer’s match.
Contributions and potential earnings grow tax-deferred until you withdraw them, usually in retirement. You’re limited to contributing $20,500 in 2022 ($22,500 in 2023) plus an additional $6,500 for employees age 50 or over. (Check back yearly, because the IRS changes the maximum contribution amount to allow for cost-of-living increases. It also changes the annual limits of Roth 401(k)s. The IRS announces additional savings opportunities for those age 50 and older.)
You can take a withdrawal from your account without being taxed as long as you take what is called a “qualified distribution.” A qualified distribution means that you must meet certain criteria — you must hold the account for at least five years or withdraw due to a disability, on or after the death of the account owner or that you reach at least age 59 ½.
What happens if you take an unqualified distribution from a traditional 401(k)? You pay taxes and penalties — potentially a 10% penalty, but it’s based on a pro-rata amount of your contributions and earnings.
You must take what is called a “required distribution” by the time you are 72 years old, unless you are employed at the company that holds the 401(k) and you are a 5% (or more) owner of the business sponsoring the plan.
Roth 401(k) Benefits
What are the benefits of investing in a Roth 401(k)? It’s important to understand the pros and cons of choosing this investment vehicle so it fits your needs now and in retirement.
Contributions are taxed at a lower tax rate
You may be taxed at a lower tax rate now rather than later. It’s possible that in order for the U.S. government to meet its obligations, it will need to raise taxes at the federal level. Therefore, it’s possible that by utilizing a Roth 401(k), you will pay taxes at the lowest tax rate now rather than later. However, it’s difficult to know what will happen with future tax rates.
Distributions are tax free in retirement
When you invest in a Roth 401(k), you pay taxes ahead of time — you don’t get a tax deduction when you contribute. Instead, your money is not subject to income tax when you withdraw it as long as you make a qualified withdrawal.
Higher vs. Lower Tax Bracket in Retirement
You can save more in terms of taxes if you can determine what the differences will be between the tax rate while you are employed and what you believe your future tax rate will be during retirement.
If you think your income and tax rate will be lower in retirement, might consider going for a traditional 401(k). However, if you believe you will have more income and be in a higher tax bracket in retirement, you’ll likely consider going for a Roth 401(k). It’s a matter of deciding when you want to encounter the tax hit — earlier or later?
You may also consider putting money into both a Roth 401(k) and a tax-deferred 401(k) if you’re not sure whether your income will be higher or lower in retirement.
Roth 401(k) Disadvantages
What are the disadvantages of a Roth 401(k)? Let’s take a look.
Contributions do not lower taxable income
As discussed, Roth 401(k) contributions are made with after-tax dollars, so it does not lower one’s income today.
If you choose a tax-deferred 401(k) plan over a Roth 401(k) plan, you’d set aside part of your pay before federal and state income taxes are withheld — they are made with before-tax dollars, as we’ve discussed.
This means you save taxes today instead of later on. In other words, money that you pay toward a Traditional 401(k) lowers your taxable income.
Let’s take a look at an example. Let’s say that your salary is $45,000, and as a single taxpayer, your tax bracket is 22%. Let’s also say you contribute 7% of your salary into a tax-deferred 401(k), which is a total of $3,150. In this case, your taxable income will go down to $41,850. You can calculate it like this:
$45,000 x 0.07 = $3,150
$45,000 – $2,100 = $41,850
Therefore, in this case, you’ll get taxed on a salary of $41,850 instead of the full amount of $45,000. The downside of a Roth 401(k) is that you don’t reduce your taxable income, unlike you would if you adopted a traditional 401(k).
Roth 401(k) Limits
Naturally, you cannot contribute any amount that you want to a Roth 401(k), there are contribution limits. In 2022, you are limited to contributing $20,500 ($22,500 in 2023) plus an additional $6,500 for employees age 50 or over. Check back every year, because the IRS often changes the income limits.
It’s worth pointing out that the limits for a Roth 401(k) are much higher than they are for a Roth IRA. The Roth IRA contribution limit is $6,000 per person ($6,500 in 2023) with a $1,000 catch-up for those over age 50.
It’s important to weigh the pros and cons of all types of retirement accounts before you choose the right type of account for you.
Whether you’re considering after tax vs. Roth 401(k) or trying to base your decisions off your adjusted gross income, it’s also a good idea to consider your preferences, risk tolerance, investment time horizon and more.
Managing your marginal income tax bracket can also give you a measure of control. It helps you choose how you want to manage your taxable income in retirement and can give you a huge advantage. Be sure to weigh all your available options to maintain your retirement goals.
Personal Capital’s free financial tools can help you match your asset allocation to your risk tolerance and other factors in order to help you put together a solid portfolio for your needs.
Get Started with Personal Capital’s Free Financial Tools