What Is a Roth 401(k)?

Roth 401K

Investopedia / Matthew Collins

What Is a Roth 401(k)?

A Roth 401(k) is an employer-sponsored retirement savings account that is funded using after-tax dollars. This means that income tax is paid immediately on the earnings that the employee deducts from each paycheck and deposits into the account. Withdrawals from the account are tax-free upon retirement.

This type of plan is different from a traditional 401(k) plan, which is funded with pretax money. In this case, payroll deductions come out of the employee's gross income and taxes are due only when the money is withdrawn from the account.

Key Takeaways

  • A Roth 401(K) is a type of employer-sponsored retirement savings plan.
  • Contributions made to Roth 401(k) are taxed but earnings and withdrawals made after retirement are tax-free.
  • The minimum age to take required minimum distributions as of Jan. 1, 2023, is 73 unless you were 72 in 2022.
  • Contribution limits are adjusted annually for inflation and are announced each year by the IRS.
  • Penalties apply if you make withdrawals before you turn 59½ or if you had the account for less than five years.

Introduction To The 401(K)

How Roth 401(k)s Work

Investors have many options when it comes to saving for retirement. One of the most common ways to put money aside is through employer-sponsored plans like the 401(k). Participation is voluntary and those who take part agree to automatic payroll deductions that are transferred into a special retirement account. Some employers even match employee contributions up to a certain amount.

There are several varieties of 401(k)s that exist. The Roth 401(k) option became available as of the beginning of 2006, while the traditional 401(k) has been around since 1978. Both were authorized by Congress as tax-advantaged retirement plans to encourage employees to save for their retirement.

Their tax advantages are different:

  • A traditional 401(k) reduces the employee's gross income for the year, giving them an instant tax break in addition to a retirement savings vehicle. The employee will owe regular income tax on every withdrawal made during retirement.
  • The Roth 401(k) requires that the income tax be paid immediately, so the employee's real net income is reduced by the amount earmarked for savings. But no further taxes will be owed on withdrawals of either the contributions or the profits earned over the years.

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.

Roth 401(k) Contribution Limits

A Roth 401(k) is subject to contribution limits based on the individual's age. These limits are adjusted annually for inflation and released by the Internal Revenue Service (IRS).

The contribution limit for individuals in $20,500 in 2022. Individuals 50 and older can contribute an additional $6,500 as a catch-up contribution. In 2023, the contribution limit rises to $22,500, and the catch-up contribution increases to $7,500. Unlike other plans, there is no income limit to participate.

Roth 401(k) Contribution Limits
 Year Less than Age 50  50 Years or Older
2021 $19,500 $26,000
2022 $20,500 $27,000
2023 $22,500 $30,000

Note that if your income is very low, you cannot contribute more than your taxable income for that year.

Roth 401(k) Withdrawal Rules

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. This means that:

  • The Roth 401(k) account must have been held for at least five years.
  • The withdrawal must have occurred because of a disability, on or after the death of an account owner, or when an account holder reaches at least age 59½.

As of Jan. 1, 2023, your first required minimum distribution (RMD) must be taken when you turn 73, as per the SECURE Act 2.0. Passed on Dec. 23, 2022, the new bill made provisions to the SECURE Act of 2019. It's important to note, though, that if you were 72 in 2022 or 70½ before Jan. 1, 2020, you can continue taking your RMDs as scheduled. That is unless you are still employed at the company that holds the plan and you aren't a 5% (or more) owner of the business sponsoring the plan.

Keep in mind that individuals can withdraw more than the RMD. But there is a penalty if you miss an RMD or if your withdrawal is less than outlined during a calendar year. Previously 50% of the value of the missed withdrawal, this penalty is now 25% of the missed withdrawal's value. You can reduce the amount of the penalty to 10% if you fix the mistake before the date that the penalty is imposed, which is known as the correction window.

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

Advantages and Disadvantages of Roth 401(k)s

A Roth 401(k) may have the greatest benefit for employees currently in a low tax bracket who expect to move into a higher one after they retire. Contributions made to a Roth 401(k) are taxed at the lower tax rate. Distributions are tax-free in retirement, making them the greatest single advantage. No matter how much the account grows over the years, that money is still exempt from income taxes after the account holder retires.

The downside is a little more immediate financial pain. Because contributions to a traditional 401(k) are not taxed immediately (but effectively reduce the amount of your gross income), the impact on your take-home pay is reduced and your tax break for the year is maximized. But there's no such deal with a Roth 401(k). This means that you are out-of-pocket for (but still taxed on) the deposits you make to it in the year you make them.

  • Helps people who believe they'll be in a higher tax bracket later in life

  • Distributions are tax-free during retirement

  • Earnings grow tax-free

  • Contributions are made using after-tax dollars

  • Contributions don't reduce your taxable income

Roth 401(k) vs. Other Retirement Accounts

As noted above, Roth 401(k) accounts are employer-sponsored plans that help people plan for retirement. But it's not the only option available to investors.

401(k) Plans

Like its Roth equivalent, the traditional 401(k) is an employer-sponsored plan. This means you can't set one up on your own. Money is taken out of your paycheck through automatic deductions and transferred into a special account. The money is then invested in a series of mutual funds that you choose.

The IRS sets limits on how much you contribute to the plan each year. This figure is adjusted annually for inflation:

  • Employees below age 50 cannot contribute more than $20,500 per year for 2022. This increases to $22,500 in 2023.
  • Those 50 and over can make a catch-up contribution of $6,000 plus $1,000 per year in 2022 and $6,500 plus $1,000 in 2023.
  • The contribution limit increases to $22,500 in 2023. If you are older than 50, you can make an additional catch-up contribution of $7,500.

Employers can also contribute to their employees' plans, so long as the total contribution does not exceed the employee's annual salary. The 2022 limit for employer-employee contributions is capped at $61,000, or $67,500 including the catch-up contribution. For 2023, those limits rise to $66,000 and $73,500 respectively.

This plan is a defined contribution plan, which means your contributions determine the account balance and how well your account performs. Contributions are made using pretax dollars, reducing the income tax you pay. Withdrawals made during retirement are subject to income tax.

Individual Retirement Accounts (IRAs)

If you don't have the option to invest in an employer-sponsored plan, you may want to consider an individual retirement account (IRA). This kind of account can be set up by anyone through a financial institution or investment firm, which means anyone who has earned income is entitled to one.

You can invest in a variety of investments under an IRA, including stocks, bonds, exchange-traded funds (ETFs), mutual funds, and real estate investment trusts (REITs). Just like the 401(k), there are several types of IRA options available:

  • Traditional IRA: Contributions made to a traditional IRA are tax-deductible, thereby decreasing your taxable income. Withdrawals made during retirement are taxed at your normal income tax rate. For 2022, you can only contribute $6,000 if you're under 50, increasing to $6,500 in 2023. You can make an additional $1,000 catch-up contribution per year if you are over 50.
  • Roth IRA: Contributions made to a Roth IRA are made using after-tax dollars. This means you can't use them to reduce your taxable income. The limits are the same as traditional IRAs. Any withdrawals you make during retirement are tax-free. Roth IRAs don't require you to take minimum distributions—or any at all. You can leave the money in your account if you choose to do so. You will be hit with a 10% early withdrawal penalty if you take money out before age 59½.

You can also choose a SEP IRA or a SIMPLE IRA if you're self-employed or work for a small business.

403(b) Plans

These plans are just like the 401(k) but are sponsored by employers for individuals who work in schools and other tax-exempt organizations. This includes teachers, professors, clergy people, doctors, nurses, government employees, and librarians.

Participants agree to regular payroll deductions. Individuals may also benefit from additional contributions by the employer if they provide 403(b)s.

These plans have the same contribution limits as regular 401(k) plans. If you have one, you can contribute a maximum of $20,500 in 2022, or $22,500 in 2023. People over 50 can make an additional contribution of $6,500 in 2022, or $7,500 in 2023.

How Do Roth 401(k) Plans Work?

Roth 401(k) plans are only available through an employer, which means you can't set one up on your own. Contributions are made using after-tax dollars through payroll deductions. The contributions grow tax-free in your account. Withdrawals are also tax-free as long as you've held the account for at least five years and you're at least 59½. The required minimum distribution must be taken for those who turn 72 in 2022 or before. That age increases to 73 after Jan. 1, 2023.

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

Your personal circumstances can help answer that question. The Roth 401(k) is generally a better deal because you only pay income taxes on your contributions. This allows your earnings to grow tax-free and make withdrawals without paying income taxes. If you're cash-strapped now, this option will be a heavier hit to your current annual income.

Contributions to a traditional 401(k) are tax-free but you must pay taxes on your withdrawals. So if you expect to be in a lower tax bracket after retiring, the immediate tax break of a traditional 401(k) may be more useful.

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

A withdrawal is only considered a qualified distribution as long as you've held the account for at least five years and you're 59½ unless you are disabled or the account holder dies.

You must make the required minimum distributions if you are at least 72 years old before 2022 unless you still work for the company that holds the 401(k) and don't have at least a 5% ownership stake in the business that sponsors the plan. You must begin taking RMDs at 73 beginning Jan. 1, 2023.

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

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 are comfortable taking.

You can also lose money in a Roth 401(k) if you break the rules and take 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.

The Bottom Line

Roth 401(k) plans allow a company's employees to start investing for their retirement. Like other 401(k) plans, there may be an employer matching contribution. However, unlike regular 401(k) plans, a Roth is funded using after-tax dollars, meaning that there are no income taxes when you take distributions during retirement.

Article Sources
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The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.