Roth 401(k)

What Is a Roth 401(k)?

A Roth 401(k) is an employer-sponsored retirement savings account that is funded with after-tax dollars.

That is, income tax is paid immediately on the earnings that the employee has deducted from each paycheck and deposited into the retirement account. Once the employee retires, withdrawals from the account will be tax free.

This differs from a traditional 401(k) plan, which is funded with pretax money. The payroll deduction comes out of the employee's gross income. The income taxes will be due only when the money is withdrawn from the account.

Many but not all employers who offer 401(k) plans offer both the Roth and traditional 401(k) options.

Understanding the Roth 401(k)

The Roth 401(k) option has been available only since the start of 2006, while the traditional 401(k) has been around since 1978. Both were authorized by Congress as tax-advantaged plans to encourage employees to save towards their retirement.

Their tax advantages are different:

Fine Print on the Roth 401(k)

A Roth 401(k) is subject to contribution limits based on the individual's age. For example, the contribution limit for individuals in 2020 and 2021 is $19,500 per year. Individuals 50 and older can contribute an additional $6,500 as a catch-up contribution.

Withdrawals of any contributions and earnings are not taxed as long as the withdrawal is a qualified distribution, which means certain criteria must be met. First, the Roth 401(k) account must have been held for at least five years. Additionally, the withdrawal must have occurred on the account of a disability, on or after the death of an account owner, or when an account holder reaches at least age 59½.

Distributions are required for those at least 72 years old (70½ before January 1, 2020) unless the individual is still employed at the company that holds the 401(k) and is not a 5% (or more) owner of the business sponsoring the plan.

Roth 401(k)s are not available in all company-sponsored retirement schemes. When they are, 43% of savers opt for the Roth over a traditional 401(k). Millennials are more likely to contribute to a Roth 401(k) than Gen Xers or baby boomers.

Unlike a Roth 401(k), a Roth IRA is not subject to required minimum distributions.

Roth 401(k) Advantages

A Roth 401(k) may have the greatest benefit for employees currently in a low tax bracket who expect to move into a higher tax bracket after they retire. The contributions will be taxed now at the lower tax rate while the distributions will be tax-free in retirement.

The greatest single advantage is the tax-free distribution. No matter how much the account grows over the years, that money will still be tax-free during retirement.

The downside is a little more immediate pain. Because contributions to a traditional 401(k) are not taxed immediately, the impact on your take-home pay is reduced and your tax break for the year is maximized.

Is a Roth 401(k) Better Than a Traditional 401(k)?

If you take the long view, a Roth 401(k) can be a better deal. You're paying income tax on your contributions in current dollars in order to build a tax-free nest egg for retirement. Crucially, both the contributions and the profits that accrue over time will be tax-free. In contrast, you'll pay income tax on the entire amount you withdraw from a traditional 401(k) account.

Some other considerations:

What Are the Criteria for Roth 401(k) Withdrawals?

Withdrawals of any contributions and earnings are not taxed as long as the withdrawal is a qualified distribution. That involves certain criteria:

The Roth 401(k) account must have been in place for at least five years.

The withdrawal must be made after the accountholder reaches age 59½ unless it is due to a disability or the death of the account owner.

Minimum distributions are required for those at least 72 years old unless the individual is still employed at the company that holds the 401(k) and is not a 5% (or more) owner of the business sponsoring the plan.

Can You Lose Money in a Roth 401(k)?

You bet! You can lose money in any investment if the market tanks. That said, most employers offer a choice of funds, including very low-risk options like government bond funds. You can mix and match choices to reach the level of risk you want to take.

In addition, you can lose money in a Roth 401(k) by breaking the rules on taking early distributions. If you're considering taking some money out early, check with the fund administrator to find out whether you might owe a tax penalty.