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Chances are you've heard of 401(k)s and Roth IRAs. These common retirement savings accounts each have their own unique benefits. A Roth 401(k), on the other hand, is a hybrid account that blends some of the best features of both types. It's an employer-sponsored, tax-advantaged savings vehicle designed specifically for retirement.
By the end of 2021, Roth 401(k)s had been adopted by 77% of Vanguard retirement plans, with 15% of participants opting for them, according to the investment management company.
Here's how a Roth 401(k) works so you can decide if it's right for you.
How a Roth 401(k) Works
To participate in a Roth 401(k), your employer must offer it in their benefits package. Contribution limits are the same as traditional 401(k)s: That's $20,500 in 2022, though folks 50 or over can kick in an additional $6,500 annually.
Traditional 401(k)s are funded with pre-tax contributions made via automatic payroll deductions. These contributions are tax-deductible, meaning they reduce your taxable income during your working years. You will be taxed on distributions you take in retirement.
A Roth 401(k) is funded with after-tax dollars. Since you've already paid taxes on the money going into the account, you can withdraw your contributions whenever you like, tax-free. It mirrors a Roth IRA in this way. However, you will be taxed on investment gains if you withdraw funds prior to age 59½ and have had the account for less than five years. A 10% penalty may also apply on withdrawals.
One other important distinction: Required minimum distributions (RMDs) apply to both traditional and Roth 401(k)s. If you're no longer working, you must begin drawing on these funds at age 72. Roth IRAs, on the other hand, are not subject to RMDs until the owner passes away.
| Roth 401(k) vs. Traditional 401(k) | ||
|---|---|---|
| Traditional 401(k) | Roth 401(k) | |
| 2022 contribution limit | $20,500; those who are 50 or older can contribute an extra $6,500 | Same as a traditional 401(k) |
| Are contributions tax-deductible? | Yes | No |
| Do required minimum distributions (RMDs) apply? | Yes | Yes |
| Are you taxed on withdrawals? | Yes | Contributions can be withdrawn at any time tax-free, but you will be taxed on investment gains if you're under 59½ and have had the account less than five years. A 10% penalty may also apply. |
| Can an employer match contributions? | Yes | Yes, but employer contributions will be funneled into a traditional 401(k). Withdrawals here are taxable. |
| Are there early withdrawal penalties? | 10% penalty if withdrawals are made prior to age 59½ | Not on your contributions, but a 10% early withdrawal penalty may apply to non-contributions (employer matches and investment earnings) |
Are Roth 401(k)s Eligible for Employer Matching Contributions?
The short answer is yes, but with some caveats. If your employer is willing to match some or all of your Roth 401(k) contributions, the amount they kick in will be funneled into a traditional 401(k) account rather than your Roth 401(k). There it will grow tax-deferred, and you'll be taxed on withdrawals you take in retirement.
Regular 401(k) rules apply to this money. These include early withdrawal penalties and required minimum distributions. Meanwhile, your personal contributions live within your Roth 401(k) account where your earnings grow tax-free.
Pros and Cons of a Roth 401(k)
Pros
- Roth 401(k)s allow for tax-free withdrawals in retirement. This can be useful if you expect to be in a higher tax bracket when you retire.
- Unlike Roth IRAs, Roth 401(k)s do not have income limits.
- Contribution limits are higher than Roth IRAs.
Cons
- Contributions are not tax-deductible.
- If your employer offers a match, their contributions go into a traditional 401(k) account. This money will be taxed as ordinary income when you make withdrawals in retirement.
- Required minimum distributions apply to Roth 401(k)s.
How Much Should You Contribute to a Roth 401(k)?
There isn't an exact formula for determining how much to contribute to your retirement accounts. To maximize your savings, you'll want to look at your unique financial situation.
Saving early and often is the golden rule of retirement planning. Folks in their 20s and 30s are generally advised to earmark 15% of their income for retirement. That number dials up to 20% for those 40 and older who have the ability to set aside more.
These are, of course, suggested benchmarks. If saving that much impacts your ability to meet your financial obligations or make progress toward other financial goals, you might want to settle on a more reasonable number. Ideally, you'll want to contribute at least enough to secure any employer match that may be on the table. Just bear in mind that, unlike a traditional 401(k), the contributions you make to a Roth 401(k) will not reduce your taxable income.
The Bottom Line
A Roth 401(k) is a retirement savings account that blends some of the best features of a Roth IRA and traditional 401(k). These accounts are offered by certain employers, who may choose to match a portion of your contributions. Roth 401(k)s have high contribution limits and unique tax advantages that could be a good fit for your overarching financial plan. Since Roth 401(k)s allow for tax-free withdrawals in retirement, they can be especially handy if you expect to be in a higher tax bracket when you retire.
A strong financial foundation is at the heart of retirement planning. Experian provides plenty of free tools to help you along the way. This includes access to your credit score and credit report whenever you need it.