When you read about 401(k) qualified retirement plans, it’s mostly assumed that it’s a traditional 401(k). Some employers also offer a Roth 401(k). In many ways, the two plans are similar; one big difference is how you’re taxed.

Tax Treatment

A Roth 401(k) is like a Roth IRA in its tax treatment. Instead of paying taxes when you withdraw money from your account – once you reach retirement – you’re taxed in the year you make the contribution.In other words, the money you put into a Roth 401(k) comes from your after-tax earnings. (By contrast, with a traditional 401(k), your contributions come out of pre-tax salary; that's why you're taxed on them when you withdraw the funds.) If you believe that you will be in a higher tax bracket once you reach retirement, a Roth 401(k) might be a better choice.

If you’re early in your career or unsure of how tax rates will trend in the future, the Roth 401(k) is probably a good way to go. Should your employer offer both, it’s best to talk to a financial professional about the differences between the two types of accounts before you decide which route to take. If you’re already investing in a Roth 401(k), here are a few ways to get the most out of your contributions.

1. Contribute up to the employer match

Many, though not all, employers match some portion of your 401(k) contribution. Even if your plan isn’t as attractive as you would like in terms of low-cost funds, the fact that your employer is giving you free money makes it worthwhile. Once you reach the maximum your employer will match, you can also contribute up to $5,500 to a Roth IRA as long as you don’t go over $17,500 in total contributions in a single year (2014 limits). This means that if you contribute $5,500 to your Roth IRA, you can contribute up to $12,000 to your Roth 401(k).

2. Speaking of an IRA

Many financial advisers suggest contributing some portion of your retirement dollars to an IRA because there are more investment options than you get in a 401(k), where the investment options are set by your employer. On the other hand, the larger range of options means that an IRA requires more financial knowledge on your part. If you don’t feel comfortable managing the account yourself, get help from a fee-only adviser who can help you find low cost investment products to maximize your return.

3. Think lower cost instead of higher return

Even the most brilliant financial minds can’t predict what the world’s economies will do in the future. The funds offered to you in your Roth 401(k) will have past performance data, but the past doesn’t predict the future. You can, however, predict the impact of fees. Look for options with low fees.

Many advisers suggest index funds over actively managed funds. Target date funds are convenient, but require the fund manager to pick the right investments to perform well just like any other actively managed fund. (For more on this, see An Introduction to Target Date Funds.) Novice investors should look at the fee structure first and stay away from funds with fees higher than 1%.

4. If you’re older, contribute more

The IRS allows for catch-up contributions for people over 50. For 401(k) plans, you can contribute an extra $5,500 making your limit $23,000 annually until you reach retirement age. Remember, any IRA contributions will lower the amount you can contribute to a 401(k).

5. Don’t make a lot of changes

A retirement account isn’t designed for short-term trading. Unless the markets are crashing around you, stay the course and let your investments ride out the natural up and down motion of the financial markets. Once per year, review your allocations and fund choices preferably with the help of a trusted professional.

The Bottom Line

A Roth 401(k) is perfect for people who believe they will be in a higher tax bracket upon retirement. Not all employers offer the Roth option. Check with your employer and if your company does offer a Roth 410(k), make an informed choice.

Related Articles
  1. Retirement

    Roth Feature Boosts Benefits For 401(k) And 403(b) Plans

    Roth accounts tend to beat Traditional plans over the long term by providing tax savings.
  2. Retirement

    Roth 401(k), 403(b): Which Is Right For You?

    Learn how to decide between a 401(k), 403(b) or Roth to help you build your nest egg.
  3. Options & Futures

    Know The Rules For Roth 401(k) Rollovers

    Rolling a Roth 401(k) into a Roth IRA is usually the optimal thing to do.
  4. Retirement

    An Introduction To The Roth 401(k)

    The money that you earn today is taxed today, making tax-free retirement withdrawals a reality.
  5. Retirement

    A Closer Look At The Roth 401(k)

    Learn about the benefits and drawbacks of this new investment account and see if it's right for you.
  6. Investing

    Five Things to Consider Now for Your 401(k)

    If you can’t stand still, when it comes to checking your 401 (k) balance, focus on these 5 steps to help channel your worries in a more productive manner.
  7. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI KLD 400 Social

    Find out about the iShares MSCI KLD 400 Social exchange-traded fund, and learn detailed information about its characteristics, suitability and recommendations.
  9. Mutual Funds & ETFs

    ETF Analysis: PowerShares DWA SmallCap Momentum

    Find out about the PowerShares DWA SmallCap Momentum Portfolio ETF, and explore detailed analysis the fund's characteristics, suitability and recommendations.
  10. Trading Strategies

    How To Buy Penny Stocks (While Avoiding Scammers)

    Penny stocks are risky business. If want to trade in them, here's how to preserve your trading capital and even score the occasional winner.
  1. Roth 401(k)

    An employer-sponsored investment savings account that is funded ...
  2. Dynamic Updating

    A method of determining how much to withdraw from retirement ...
  3. Possibility Of Failure (POF) Rates

    The likelihood that a retiree will run out of money prematurely ...
  4. Safe Withdrawal Rate (SWR) Method

    A method to determine how much retirees can withdraw from their ...
  5. Qualified Longevity Annuity Contract

    A Qualified Longevity Annuity Contract (QLAC) is a deferred annuity ...
  6. Systematic Manager

    A manager who adjusts a portfolio’s long and short-term positions ...
  1. What are the main differences between a Roth 401(k) and a 401(k)?

    Many investors have questions about the investment options of a Roth 401(k) vs 401(k). A Roth 401(k) and a traditional 4 ... Read Full Answer >>
  2. I am rolling my 401(k) into an IRA. After a year, can I convert this amount to a ...

    There is no provision in the tax law that would allow anyone to convert taxable funds and treat it as a tax-free transaction, ... Read Full Answer >>
  3. Are spousal Social Security benefits taxable?

    Your spousal Social Security benefits may be taxable, depending on your total household income for the year. About one-third ... Read Full Answer >>
  4. Are spousal Social Security benefits retroactive?

    Spousal Social Security benefits are retroactive. These benefits are quite complicated, and anyone in this type of situation ... Read Full Answer >>
  5. Do penny stocks pay dividends?

    Because of the small market capitalization and revenues typical of most penny stocks, there are very few that offer dividends. ... Read Full Answer >>
  6. Can you buy penny stocks in an IRA?

    It is possible to trade penny stocks through an individual retirement accounts, or IRA. However, penny stocks are generally ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!