An Introduction to the Roth 401(k)

The Roth 401(k) account made its debut in the retirement investment community in 2006. Created by a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 and modeled after the Roth IRA, the Roth 401(k) is an employer-sponsored investment savings account that allows employees to save for retirement with after-tax money.

Participants in 403(b) plans are also eligible to participate in a Roth account. Although the ability to contribute to a Roth 401(k) was originally set to expire at the end of 2010, the Pension Protection Act of 2006 made the Roth 401(k) permanent.

Key Takeaways

  • A Roth 401(k) is an employer-sponsored savings plan that gives employees the option of investing after-tax dollars for retirement.
  • Contribution limits for 2022 are $20,500 and for 2023 are $22,500. In addition, individuals 50 and older are allowed a catch-up contribution of $6,500 in 2022 and $7,500 in 2023.
  • Although you pay taxes on your contributions, withdrawals that you take after age 59½ will be tax-free if the account has been funded for at least five years.
  • Unlike a Roth IRA, you must take RMDs from a Roth 401(k) starting at age 73 or 75, depending on the year you were born.
  • People whose taxes are currently low or who expect to pay higher taxes in retirement may benefit from opening a Roth 401(k).

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Roth 401(k) Benefits

The benefits associated with the Roth 401(k) depend largely on your point of view. From the government's perspective, the Roth 401(k) generates current revenue in the form of tax dollars. That's different from a traditional 401(k), for which investors receive a tax deduction on their contributions. Thanks to this deduction, funds that ordinarily would be lost to the IRS remain in the account tax-deferred until they're withdrawn. 

From the investor's perspective, the account is expected to grow over time, and money that would have been lost to taxes will instead spend all of those years working for the investor. The government also wants those assets to grow because the tax deferral ends when the money is withdrawn from the account. In essence, the government gives you a tax break today in the hope that there will be even more money to tax in the future.

The Roth 401(k) works in reverse. The money you earn today is taxed today. When you put this after-tax money into your Roth 401(k), withdrawals that you take after you reach age 59½ will be tax-free if the account has been funded for at least five years. The prospect of tax-free money during retirement is attractive to investors.

The prospect of tax dollars being paid today instead of deferred is attractive to the government. In fact, it's so attractive that lawmakers have discussed eliminating traditional tax-deductible IRAs and replacing them with accounts such as the Roth 401(k) and Roth IRA.

The Rules

An investor can contribute to a Roth 401(k), a traditional 401(k), or a combination of the two, assuming both are offered by their employer. The total annual additions paid into a participant's account can't exceed 100% of the participant's compensation for the year. Alternatively, the annual addition is capped at $66,000 in 2023 (or $73,500 for individuals eligible for catch-up contributions.

An individual's personal contribution limits remain the same regardless of whether you choose a traditional account, a Roth, or both. The contribution limit for 2022 was $20,500, and the contribution limit for 2023 is $22,500. Individuals 50 or over can also make catch-up contributions. In 2022, the catch-up contribution limit was $6,500, and the catch-up contribution limit in 2023 is $7,500.

The contribution limit is one advantage that a Roth 401(k) has over a Roth or traditional IRA: The total amount you can contribute to those IRA accounts is $6,000 a year ($7,000 if you're 50 or over) in 2021 and 2022, now $6,500 ($7.500 if you're 50 or over) for 2023.

The decision regarding which plan you choose depends largely on your personal financial situation. If you expect to be in a higher tax bracket after retirement than you are in your working years, the Roth 401(k) may be the way to go—it will provide tax-free withdrawals when you retire.

While it may seem intuitive that most investors will experience a decrease in their tax rate upon retirement, retirees often have fewer tax deductions, and there's also the potential impact of future legislation, which could result in higher tax rates. Considering the uncertainty of tax rates in the future, young workers who currently have lower income tax rates may want to consider investing in after-tax programs like the Roth 401(k), essentially locking in the lower tax rate.

Factors To Consider

There are a number of factors that may influence whether or not you decide to open a Roth 401(k).

  1. Your company may not offer the Roth 401(k). Doing so is voluntary for employers, and in order to offer such a plan, employers must set up a tracking system to segregate Roth assets from the company's current plan. This may be an expensive proposition, and your employer may choose not to do it.
  2. Unlike Roth IRAs, Roth 401(k) participants are subject to required minimum distributions at age 73 if they were born between 1951 and 1959 or age 75 if they were born in 1960 or after, which forces investors to take distributions even if they don't need or want them. 
  3. The distribution requirement can be avoided by rolling over to a Roth IRA, but doing so is an administrative hassle, and legislators may change the rules at any time to forbid such transfers.
  4. Having both a Roth and a traditional 401(k) will allow you to take money from your tax-free and/or tax-deferred accounts, which can help you manage your taxable income in retirement.

Any matching contributions your employer makes to your Roth 401(k) must be deposited into a traditional 401(k) account.

How Does a Roth 401(k) Work?

A Roth 401(k) is an employer-sponsored plan in which an employee can make retirement contributions into the account. The employer may then match contributions and set vesting schedules to provide additional benefits to the employee. A Roth 401(k) is funded using after-tax contribution dollars, meaning any investment growth will occur tax-free.

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

For some, a Roth 401(k) is better than a traditional 401(k). With a Roth 401(k), retirement contributions are made after taxes have been paid on those contributions. In return, any investment growth in the portfolio of a Roth 401(k) grows tax-free. Alternatively, a traditional 401(k) has better tax advantages upfront; however, future earnings are taxable when withdrawn in the future.

Broadly speaking, a Roth 401(k) is better for lower-income individuals who expect to be in a higher tax bracket in the future. Alternatively, a traditional 401(k) is usually better for current high earners who expect their tax bracket to fall in the future.

What Is the Downside of a Roth 401(k)?

Contributions made into a Roth 401(k) are after-tax contributions. This means there is no tax benefit for these retirement contributions. Other forms of retirement savings offer better current, immediate tax incentives.

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

Whether it is a Roth account or a traditional account, a 401(k) is a retirement savings account managed by your employer. You have less flexibility with a 401(k) as you must use the financial institution or broker they select, and your investment options may be limited; however, you may be eligible for matching contributions with a 401(k).

Alternatively, an IRA is a self-managed account. You get to select who holds your account, and you usually have many more investment options to choose from; however, there is no contribution matching from an outside source for any IRA.

The Bottom Line

It's wise to assess your current tax rate versus your expected future tax rate before making your decision about investing in a Roth 401(k). A tax rate that's lower now than what you expect later makes this type of account attractive, but if the opposite is true, tax-deferred programs are probably a better option.

Article Sources
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  1. National Bureau of Economic Research (NBER). "Who Uses the Roth 401(k)?"

  2. U.S. Congress. "Economic Growth and Tax Relief Reconciliation Act of 2001."

  3. Internal Revenue Service. "IRC 403(b) Tax-Sheltered Annuity Plans."

  4. U.S. Congress. "Pension Protection Act of 2006."

  5. Internal Revenue Service. "Roth Account in Your Retirement Plan."

  6. Internal Revenue Service. "401(k) Limit Increases to $22,500 for 2023, IRA Limit Rises to $6,500."

  7. U.S. Senate, Committee on Finance. "SECURE 2.0 Act of 2022," Page 2.

  8. Internal Revenue Service. "Roth Comparison Chart."

  9. Internal Revenue Service. "Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits."

  10. Internal Revenue Service. "IRS Announces 401(K) Limit Increases to $20,500."

  11. Internal Revenue Service. "Rollover to a Roth IRA or a Designated Roth Account."

  12. Internal Revenue Service. "Retirement Plans FAQs on Designated Roth Accounts."

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