Roth 401(k) and Roth 403(b) plans can be a smart choice if you want tax-free income in retirement and are willing to pay some taxes upfront. Here's a look at how the plans work, some of their pros and cons, and how they stack up against traditional 401(k) and 403(b) plans.
- If your employer offers a Roth 401(k) or Roth 403(b), you'll pay taxes now but not in retirement.
- Unlike Roth IRAs, Roth 401(k)s and Roth 403(b)s aren't subject to income limits, so you're eligible no matter how much you earn.
- You can avoid required minimum distributions by rolling over the account into a Roth IRA.
How Roth 401(k) and 403(b) Plans Work
Roth 401(k) and 403(b) plans work much the same as traditional plans, except that they are funded with after-tax contributions and taxed similar to a Roth IRA.
As with Roth IRAs, employees can withdraw their contributions at any time, tax-free. Other withdrawals will also be tax-free, provided they count as qualified distributions. Specifically, the employee must at least 59½ years old or disabled and have had a Roth for at least five years. There are different distribution rules for beneficiaries who inherit a Roth after the original account holder dies.
The maximum contribution (for 2019) is $19,000, plus an additional $6,000 catch-up contribution for employees who are at least age 50 by the end of the year (total: $25,000). However, only the employee's contributions can go into the Roth account; any matching contributions from the employer must go into a traditional pretax account, and they will be taxed upon withdrawal.
Roth vs. Traditional IRAs & 401(k)s
Pros and Cons of Roth Plans
Roth 401(k) and 403(b) plans have advantages and disadvantages—not only compared with traditional 401(k)s and 403(b)s but with Roth IRAs. Here is a brief rundown:
Favorable tax treatment in retirement. Like Roth IRAs, contributions to Roth 401(k) and 403(b) plans are made with after-tax dollars, so there's no initial tax break. Withdrawals, however, can be tax-free. This provides a couple of advantages over traditional 401(k) and 403(b) plans. First, and most obvious, is the tax-free income. Another is that distributions from traditional 401(k)s count as ordinary income, which can affect the taxability of a retiree's Social Security benefits and potentially raise their tax bracket.
A way around required distributions. Unlike Roth IRAs, Roth 401(k)s and 403(b)s are subject to required minimum distributions (RMDs) after the account holder reaches age 70½, much like a traditional 401(k) or 403(b) account. However, if the account holder rolls over their plan balance into a Roth IRA, they won't have to worry about RMDs during their lifetime. This not only gives a retiree greater flexibility but also makes it possible to leave more of the account to their heirs than they could with a traditional plan.
Not all employers offer them. Although Roth 401(k)s and 403(b)s are becoming more widespread, not every employer offers one as an option. But note that if you're self-employed, either full-time or part-time, you could be eligible to establish an independent 401(k) and designate money you contribute to it as Roth contributions. These plans can also have higher contribution limits than other 401(k) plans, if you qualify as a sole proprietor.
No income limitations, unlike Roth IRAs. One of the advantages that Roth 401(k) and 403(b) plans have over Roth IRAs is that they are not subject to income limits. In 2019, an executive making $300,000 per year can shelter up to $19,000 ($25,000 if 50 or older) in a Roth 401(k) or 403(b). At that income level, they would not be eligible to make any contribution at all to a Roth IRA.
A $19,000 Roth contribution made annually for 20 years, earning a relatively conservative rate of 5% a year, would add up to more than $653,000. That doesn't include any catch-up contributions or increases in the maximum allowable contribution. Plus, all of that money is tax-free if the account holder meets the Roth's qualified distribution requirements.
Lower-salaried employees can contribute to a Roth 401(k) or 403(b) plan at work and still make contributions to a Roth IRA, as long as their incomes do not exceed the IRA's threshold amount. In 2019 anyone who is married, files taxes jointly, and has a modified adjusted gross income of less than $193,000 is eligible for a full IRA contribution of $6,000 (or $7,000 with a catch-up contribution). So their total contribution to the Roth 401(k) or 403(b) plus the Roth IRA could be as high as $25,000 (or $32,000 with both catch-up contributions).
An employee who contributed $19,000 to a Roth 401(k) or 403(b) plus $6,000 to a Roth IRA for a 20-year period, and whose accounts grew at an annual rate of 5%, would end up with more than $850,000—all of it potentially tax-free.
In most scenarios, Roth 401(k)s and 403(b)s come out ahead of their traditional counterparts.
So Which Is Better: Roth or Traditional Plans?
Conventional wisdom says it's important to know whether you will be in a higher or lower tax bracket in retirement before deciding between a Roth or a traditional plan. In many cases, though, this may not matter.
For example, Sally Saver is in the 24% tax bracket and works for an employer that offers a Roth 401(k). She dutifully saves $15,000 a year in her Roth account for 30 years. But because she is making after-tax contributions, her contributions are actually costing her $18,360 a year ($15,000 plus $3,600 in taxes because the amount is not tax-deferred). Therefore, at the end of 30 years, she will have paid a total of $108,000 in taxes on her Roth contributions.
Meanwhile, her friend, Nancy Now, makes contributions to a traditional 401(k). Nancy is also in the 24% tax bracket and enjoys an annual tax reduction of $3,600 on her contributions because they are made on a pre-tax basis. Therefore, she reduces her taxes by a total of $108,000 over 30 years. Assuming that both women earn an average of 5% on their investments, they will each have nearly $1 million in their plans by the time they retire.
Now assume that both Sally and Nancy begin drawing money from their plans at the end of the 30-year period, that they remain in a 24% tax bracket, and they each withdraw $50,000 a year. Nancy must pay $12,000 per year on her distributions, while Sally pays nothing. If both women live for another 30 years, Nancy will have paid a total of $360,000 in taxes on her 401(k) distributions. In addition, Nancy's distributions will likely trigger at least a partial tax on her Social Security benefits.
The Bottom Line
This scenario above is a telling example of the benefit of biting the bullet and paying taxes now instead of later, if you can afford to. Although such variables as changes in tax rates, longevity, and investment performance must also be taken into account, the Roth account tends to beat the traditional plan in most scenarios like these.
However, disciplined savings can change the equation somewhat. You'll remember that Nancy Now saved $3,600 a year in tax reductions by putting her money in a traditional 401(k). If she had invested those savings every year, and earned 5% on the money, she would have about $240,00 after 30 years—enough to pay a significant chunk of the taxes on her IRA withdrawals.