What Exactly is a Roth 401(k)?
A Roth 401(k) is a retirement account that combines the features of a traditional 401(k) and a Roth IRA. Like a traditional 401(k), it’s an employer-sponsored account eligible for employer match programs. But like a Roth IRA, contributions are made on an after-tax basis, allowing investments to grow tax-free — ultimately be withdrawn tax-free — in retirement.
Roth 401(k) accounts help you automate your personal finances since the contributions are deducted from your paycheck and invested into the account.
Some limitations and regulations to remember with your Roth 401(k) include annual contribution limits, Required Minimum Distribution (RMD) rules in retirement*, age limits for qualified distributions, and a 5-year rule when it comes to withdrawing funds. We will explore these rules in-depth later in the article.
One significant benefit distinguishing a Roth 401(k) from a Roth IRA is the potential to lock in matching contributions. Since it is an employer-sponsored plan, some companies will have employer contribution programs through which you’ll receive additional deposits.
Not all employers offer this, so find out if it applies to you. Since the IRS sets fairly strict income limits for direct Roth IRA contributions, a Roth 401(k) can allow taxpayers in every tax bracket to benefit from the Roth tax structure.
*Note that 401(k) RMDs will cease beginning in 2024.
How a Roth 401(k) Works
A Roth 401(k) is one of many possible retirement savings plans your employer may offer. When you choose to enroll, you’ll agree to have automatic payroll deductions, meaning your contributions to the Roth 401(k) account will be deducted upfront — before you receive your paycheck — making it easy to automate your savings.
When you enroll in a Roth 401(k), similar to a traditional 401(k), you’ll be provided with a set of investment options which typically includes mutual funds and ETFs. If you’re unsure which ones to choose, it’s wise to speak to a financial advisor and conduct thorough research before making final decisions.
Both the traditional 401(k) and the Roth 401(k) offer immense tax benefits. To encourage earners to save for retirement, the government and IRS offer tax advantages to incentivize participation.
The advantages take a different form for each account type:
- With a traditional 401(k), you invest pre-tax dollars, reducing your taxable income (getting a tax break) and boosting your retirement savings.
- With a Roth 401(k), you invest post-tax dollars, which are then rewarded with tax-free withdrawals when you take money out in retirement.
Contribution Limits for the Roth 401(k)
Roth 401(k) contribution limits are based on your age and are adjusted annually by the IRS based on inflation. Typically, the limits are the same as those for a traditional 401(k).
The Roth 401(k) contribution limit is higher than other Roth options, like the Roth IRA, where you are restricted by your modified adjusted gross income (MAGI) level.
Roth 401(k)s also offer catch-up contributions for those aged 50 and older looking to accelerate savings as they approach retirement.
In 2023, the Roth 401(k) individual contribution limits are as follows:
- For those under 50: $22,500
- For those 50 and over: $22,500, plus a $7,500 catch-up contribution, for a total of $30,000.
Remember that Roth 401(k)s are eligible for potential employer matching programs. Proceeds from employer matches don’t count toward your taxable income.
Because of this, there are total contribution limits, which combine employee contributions and employer contributions.
For 2023, the Roth 401(k) total contribution limits are:
- For those under 50: $66,000
- For those 50 and over: $66,000, plus a $7,500 catch-up contribution, bringing it to $73,500.
Roth 401(k) Withdrawal Rules
The main benefit of a Roth 401(k) is the potential for tax-free withdrawals in retirement. This is the case as long as you make qualified withdrawals — meaning that they meet specific criteria outlined by the IRS.
Before considering any of the following rules, note that your Roth 401(k) account must be at least five years old to make a qualified distribution — this is known as the five-year rule.
Here are the three categories of Roth 401(k) withdrawals:
- Qualified distributions: Tax-free withdrawals made after age 59 1/2. Qualified distributions allow you to avoid tax on Roth 401(k) earnings and allow you to skip out on any tax penalties.
- Hardship distributions: Early withdrawals made because of an “immediate and heavy financial need,” according to the IRS, with specific permitted circumstances. In some cases, hardship distributions will avoid the 10% early withdrawal penalty and any ordinary income tax on the earnings portion of the distribution.
- Non-qualified distributions: Early withdrawals made before age 59 1/2 that don’t meet any of the above criteria. If you make a non-qualified distribution, you’ll have to pay income tax and early withdrawal penalties on the earnings portion of your Roth 401(k) withdrawal.
Roth 401(k) Advantages and Disadvantages
Like every investment vehicle, there are upsides and downsides that you need to consider. One main advantage of a Roth 401(k) is that qualified distributions are tax-free in retirement because of your after-tax contributions, allowing you to withdraw your earnings without income taxes and/or early withdrawal penalties.
However, there are also disadvantages. If you’re a high earner, you won’t receive any tax benefit in the current year by contributing to a Roth 401(k). In fact, particularly high earners might find it too costly to use the Roth 401(k) because tax deferral is, by contrast, too valuable.
If you’re choosing between a Roth 401(k) and a Roth IRA, traditional IRA, or tax-deferred traditional 401(k), consider RMDs, the value of tax-deferral, and withdrawal rules, amongst other considerations before making your final choice.
Always speak to a qualified financial planner fluent in wealth management (a financial advisor) who can help you customize your retirement needs through an employer-sponsored plan or an Individual Retirement Account.
A Roth 401(k) account combines some of the best features of an employer-sponsored 401(k) plan and a Roth IRA account. Roth 401(k) employer plans allow employees to begin saving for retirement while benefiting from employer matching programs and tax-free growth.
When choosing your retirement account and savings plans, it’s essential to get professional help and guidance. Capitalize is here to be your trusted partner and will manage the consolidation of your retirement savings.
Learn more about how we can help you find and consolidate old retirement accounts.